Understanding Inflation and What It Means to You
Inflation sounds scary. Without even knowing what it means, it certainly feels like a bad thing that you don't want to happen. But inflation is a complicated topic. So let's keep it simple: what is inflation, why does it happen, and what does it mean for your bank account?
What is Inflation?
Inflation is the steady and persistent increase in the general price level of goods and services in an economy over a period of time. When inflation occurs, each unit of currency you hold buys fewer goods and services than it did before. In other words, your money loses its purchasing power.
In August 2023, inflation on all goods in the U.S. rose by 3.7%. That means, on average, the things you bought in August cost about 4% more than they had in July. And that's one month. If you've been maintaining the same buying habits since before the pandemic started in 2020, you've probably noticed that your bills and receipts have been getting progressively steeper.
What Causes Inflation?
Inflation, like a lot of market conditions, usually comes down to supply and demand. Specifically, when the demand significantly outpaces the supply.
This may seem deeply counterintuitive, but inflation is often caused by an increase in the supply of money within an economy. When there's more money circulating, people have more to spend, which drives up demand and, subsequently, prices, creating a very expensive loop. The more money we all have, the less it can buy us.
Economically, we're still very much feeling the effects of the coronavirus pandemic, specifically in the ways that the pandemic impacted supply chains and slowed production. Consumers are essentially competing with each other over a smaller-than-usual supply of goods, which is driving the price of those goods up. And that, in turn, reduces our spending power.
The top reasons for inflation are typically one of the following:
- Demand-Pull Inflation, where the demand for goods and services exceeds their supply, leading to price increases.
- Cost-Push Inflation, where the cost of production rises, perhaps due to increased wages or raw material costs, and businesses pass these costs onto consumers, resulting in inflation.
- Monetary Policy, which includes actions taken by central banks, such as increasing the money supply and thus creating inflation.
- Fiscal Policy, which is when government spending and taxation policies create inflation.
Types of Inflation
Inflation can be categorized into three main types:
- Moderate inflation, which is defined by a low and steady increase in prices over time.
- Hyperinflation, which is an extremely rapid and out-of-control increase in prices, often seen in economic crises.
- Stagflation, which is a dangerous combination of an economy that isn't growing but is also experiencing high inflation.
How Inflation Affects Consumers
The biggest affect of inflation on everyday consumers is the most obvious: the goods you need and rely on become increasingly more expensive. If you've recently walked out of grocery store, looked at your receipt, and asked yourself, "How on Earth did I spend so much money?" you're not alone. Things are more expensive right now.
Of course, not everything rises all the time. Month-to-month, day-to-day, the cost of individual goods is always rising and falling. The cost of apples may go up, while the cost of bed sheets goes down. So even if you're experiencing pain in the wallet right now, that doesn't necessarily have to be permanent pain.
Can inflation impact the cost of living?
Inflation can impact almost everything, including the cost of rent and the price of homes. When you consider all of the costs of living, from rent to electricity to food and more, you can expect everything to be more expensive during periods of inflation.
How does inflation affect my savings and investments?
Generally speaking, inflation makes your money worth less (though not "worthless"), and that includes your savings. Savings and investments are usually growing over time, but if inflation is high enough, then the loss in value may actually outpace the whatever growth you're seeing, making your nest egg less valuable over time.
Is there a way to protect my investments from inflation?
Investing in assets that tend to appreciate in value over time, like stocks and real estate, can provide a hedge against inflation. Additionally, some investments are specifically designed to protect against inflation, such as Treasury Inflation-Protected Securities (TIPS).
Can inflation ever be a good thing?
In some cases, a mild level of inflation can be beneficial for an economy when it encourages spending and investment, which can lead to economic growth. However, a little goes a long way, and excessively high inflation is usually a problem.
There's not much you as an individual can do about inflation. The best you can do is protect yourself and your finances by paying down costly debt and being mindful of your spending when prices start to rise. If you need help finding ways to spend less or save more, we offer free creditor counseling, online and over the phone, 24/7. Get confidential, professional advice as soon as you need it.