What Is Inflation And How To Protect Yourself From This Economic Mugger?
Ever wondered why your house rent increases virtually every year? Why prices on some of the things like prescription drugs, college tuition fees has gradually increased year-over-year? Why do you have to pay more to fill up your gas tank or buy a gallon of milk? This sustained increase in the price of goods and services is what is called as inflation.
In this article, I will explain what inflation is and what are some of its causes. I will also touch upon how inflation impacts your life. Finally, I will discuss some of the ways to protect yourself.
“Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”
— Former U.S President Ronald Reagan
What is inflation?
Inflation is defined as a gradual, yet sustained increase in the general price levels of goods and services. It’s usually over a month or a year. The percentage tells you how quickly prices rose during the period.
Usually in an inflationary environment, prices of things increase over time. In other words, every dollar you own buys you a smaller percentage of the real, tangible goods or actual services as time progresses. This is called as erosion in the purchasing power of money. For example, if the inflation rate for a gallon of milk is 2 percent a year, then milk prices will be 2 percent higher next year. That means a gallon that costs $2.00 this year will cost $2.04 next year.
Remember: When inflation goes up, purchasing power of money goes down.
As published on June 12, 2018 by the U.S. Labor Department, the inflation rate in the United States end of May 2018 was 2.8%.
Geek Stuff: Calculating Inflation Rates
Annual rates of inflation are calculated using 12-month selections of the Consumer Price Index (CPI).
For example, to calculate the inflation rate for May 2018, subtract its CPI of 251.588 from last year’s May 2017 CPI of 244.733. The result is 6.855. Divide this number by the May 2017 CPI and then multiply by 100 and add a % sign.
The result is May’s inflation rate of 2.8%.
Causes of Inflation
There are primarily two causes of inflation:
- Demand-Pull Inflation: This type of inflation occurs when the demand for a good or service increases so much that it far outweighs the supply. This gives the seller a luxury to raise prices. However, if many sellers do hike up prices, it creates inflation.
- Cost-Push Inflation: This type of inflation occurs when the shortage of supply in combination with enough demand allows the producer of a good or service to raise prices.
How Does Inflation Impact Your Life?
- Inflation hurts your buying power: You have to pay more for the same goods and services. If you own an asset like housing or stocks, you can actually benefit from asset inflation. But your buying power declines, if your income doesn’t keep up with inflation. Over time, your cost of living increases as inflation increases.
- Effect on Retirement Planning: Inflation has a tremendous impact on your retirement planning. Your savings will buy less as time progresses. As a result, you should save more than you think you will need to be prepared for inflation during retirement.
- Impact on Treasury Bonds: If you hold fixed-income assets like bonds or Treasury notes and inflation rises faster than the return on these assets, they become less valuable.
How to Protect Yourself?
The most common yet competitive way to protecting yourself from inflation is to increase your income and earning ability.
An alternate way, depending on your financial situation and savings, is to invest in the stock market. There are risks associated, however, you can meet with a financial planner or take advice from a finance professional before making a financial decision. The low-cost, tax-effective, no-brainer way of achieving market returns that mostly beats inflation rate is through an index fund.
Another way to protect yourself from inflation is using financial instruments offered by the U.S Treasury.
Treasury Inflated Protected Securities (TIPS): These pay a fixed interest rate. Depending on changes in the Consumer Price Index (CPI), the government re-adjusts the principal twice a year.
Remember: As inflation increases, the value of the TIPS bond increases.
TIPS are good securities to hold for the short-term when you realize inflation is rising, but do not do well during non-inflation. However, over the long-term, a well-diversified portfolio of stocks perform better than TIPS.
You can find more information about purchasing TIPS directly from U.S Treasury here.
Series I Bonds: They offer a guaranteed fixed rate of return for the life of the bond. They are affected by a variable rate that is indexed to the CPI, and is re-adjusted twice a year. The return you get for the bond is a composite of its fixed rate and the variable rate in effect at that time. You can find out each bond’s return using a Savings Bond Calculator.
After reading this article, hopefully you should have some insight into inflation and its impact on your life. A key takeaway on inflation is it erodes the purchasing power of money and you should always take into account the current inflation rate while calculating your returns on any kinds of investments.
Other articles by me
- How To Build Wealth Passively Using Dividend Reinvestment Plans?https://firstname.lastname@example.org/investing-using-drips-dividend-reinvestment-plans-17ed6b6c3e22
- Fundamental Analysis Using Company’s Income Statement https://email@example.com/stock-investing-fundamental-analysis-using-companys-income-statement-37b0d80531f1
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- Fundamental Analysis Using Key Ratios https://firstname.lastname@example.org/stock-investing-fundamental-analysis-using-key-ratios-ed02f32e88ae
Amrut is a Full Stack Software Engineer who is passionate about tech and software development in Web and Mobile. He likes to write about coding, investing, finance and neuroeconomics. He strongly believes in adding value to people’s life through quality work. He also loves to watch and discuss about American Football.