As an American adult of (ahem) a certain age, I can’t help noticing how much more things cost now than they did when I was a kid. Since the 1980s, the price of a gallon of milk has risen from around $2.20 to $3.50, a 59% increase. The cost of a first-class stamp has more than doubled. Paperback books have roughly tripled in price, from under $5 in 1988 to $14 or more in 2020.
Of course, there are a few items for which prices have actually fallen since the ’80s, such as clothing and electronics. But for most things, pricing has gone steadily upward. There’s a name for this phenomenon: inflation.
Inflation whittles away the value of your money, making each dollar worth less and less over time. Yet economists say it’s also a normal and even useful part of a healthy economy. By understanding how inflation can be both helpful and harmful, you can learn to plan for it, using it to your advantage and protecting yourself against its more negative effects.
What Is Inflation?
The Bureau of Labor Statistics (BLS) defines inflation as “the overall general upward price movement of goods and services in an economy.” Looking at it another way, inflation is the overall decline in the value of money, since the more prices go up, the less each dollar is worth. Back in 1988, a dollar could buy you four postage stamps; today it gets you less than two.
The main way governments measure inflation is through the Consumer Price Index, or CPI. To calculate CPI, the government puts together a theoretical “basket” of goods and services a typical consumer might buy — rent, food, transportation, and so on. The total cost of all these items is the CPI.
The government keeps track of inflation by measuring and reporting how the CPI changes from month to month and from year to year. When people talk about the inflation rate, they typically mean the change in the CPI over the past year.
Data from the Federal Reserve Bank of Minneapolis shows the CPI for the years 1913 through 2021. Its highest point was 17.8% in 1917, meaning that prices rose by nearly 18% in that one year.
The CPI’s lowest level was negative 10.3% in 1932. During that year, the economy was in a period of deflation, when overall prices were actually falling. This is most likely to happen during a recession, when many people are out of work and are cutting back on spending.
Since the 1990s, inflation in the U.S. has been fairly low. However, in 2021, there were signs that it was beginning to creep upward again. As of July 2021, the estimated annual inflation rate was 4.8%, up from just 1.2% in 2020.
That’s still lower than it was in 1990, but it’s a big enough jump to make some people concerned. CNBC reported in May that some stock traders were concerned about how inflation might eat into their investment returns. However, the story goes on to say that economists see the rise in prices as a temporary blip — and maybe even a good thing for the economy.
Effects of Inflation and How to Protect Yourself
At first glance, inflation seems like nothing but a rip-off — stealing the value of your dollars and giving you nothing in return. However, economists generally see a modest level of inflation — say, 1% to 3% per year — as a sign of a healthy economy.
When the economy is growing, consumers have more money to spend, and their higher spending drives prices up. And, since wages usually go up along with prices, their overall purchasing power stays more or less the same.
That doesn’t mean inflation is harmless. It can take a serious toll on lenders and anyone who’s living on a fixed income. However, if you know what to expect from the inflation rate, you can factor it into your financial decisions and avoid its worst effects in both the short and long term.
1. Cost of Living
The most obvious effect of inflation is that it raises the cost of living. The more prices of goods and services go up, the more you spend each year on your overall expenses — housing, food, fuel, health care, and so on.
However, in most cases, price increases don’t affect all goods equally. For example, in July 2021, the BLS reported that prices of used cars and trucks had risen by more than 10% in June. Energy, especially gasoline, also rose noticeably in price. However, the CPI as a whole rose by less than 1% for the month.
There are several ways to cope with inflation’s effect on the cost of living. First of all, do your best to keep your income growing at least as fast as your expenses. If you’re working, your salary may rise on its own or you can negotiate it higher. Otherwise, adjust your investments so they’ll bring in enough extra money to make up for rising prices.
Second, since some prices go up faster than others, keep a sharp eye on the cost of specific items in your budget. For instance, if gas prices are rising especially fast, you can make up for it by biking to work, carpooling, and generally driving less. If that’s not enough, you can adjust your household budget, putting more money toward gas and cutting back in other areas.
Finally, if you’re currently planning a major purchase, such as a new car, make it as soon as you can afford it. If inflation is at 5% per year, a car that costs $30,000 this year will cost $31,500 next year, and it will only go up from there. The sooner you pull the trigger on the purchase, the less you’ll pay.
For workers, one good effect of inflation is that it tends to drive up wages. This happens because prices are most likely to rise when consumers are buying more. This increased demand gives companies an incentive to produce more, which means they need to hire more workers.
However, when the economy is strong, workers have lots of jobs to choose from, so employers have to offer higher wages in order to compete. These higher wages, in turn, drive prices still higher. Businesses raise their prices to make up for their higher labor costs, and consumers are willing to pay these higher prices because they have more money in their pockets.
This benefit doesn’t affect all workers equally, however. Workers in the most competitive industries, where hiring is tight, gain the most. They’re in the strongest position to ask for a raise that’s higher than the rate of inflation, so they actually come out ahead.
The workers who suffer the most are those in unskilled jobs. These workers often earn only the federal minimum wage, which has been fixed at $7.25 per hour since 2009. According to a 2017 report from the Pew Research Center, the workers most likely to earn minimum wage include cashiers, sales clerks, cooks, restaurant servers, and cleaning staff.
As inflation drives prices up, unskilled workers like these have to pay more for everything they buy. However, because the minimum is fixed, their income stays as low as ever. According to Pew, by 2017 the federal minimum wage had already lost nearly 10% of its purchasing power to inflation since the last time it was raised.
Thus, if you’re in one of these low-wage occupations, one of the best forms of inflation protection is getting a better job. If possible, look for a job in a field that’s expected to grow in today’s economy. And if you already have a good job, keep an eye on the inflation rate as you negotiate for a raise or promotion, and aim for a rise in salary that will outpace the rise in prices.
The main reason inflation tends to drive wages up is that it lowers the unemployment rate. As noted above, inflation tends to go hand-in-hand with high consumer demand, and high demand drives companies to hire more workers so they can produce more.
In general, this is a good thing for the economy as a whole. People who are working and earning spend more than those who are unemployed, and their spending keeps the economy growing.
However, high inflation doesn’t always mean high growth. In the late 1970s and early 1980s, the U.S. experienced “stagflation” — a mixture of inflation and economic stagnation, or low growth. A chart from the Federal Reserve shows that the CPI at this time was growing at a rate of 5% to 15% per year, yet the unemployment rate was also well above 5%.
In most cases, though, inflation is higher in a growing economy than in a slowing one. That makes a period of higher inflation a good time to look for a new job. Employers are more likely to be hiring, and workers are more likely to have jobs already, so there’s less competition for the jobs that are available.
4. Government Benefits
Inflation can be a good thing for workers, but it’s an unquestionably bad thing for anyone who’s living on a fixed income — that is, an income that never changes, no matter what happens to the economy. Examples include retirees living on Social Security benefits and disabled people receiving Social Security Disability Insurance (SSDI).
In theory, these benefits automatically change each year to make up for inflation. According to the Social Security Administration, the Cost of Living Adjustment (COLA) for 2021 is 1.3%. So, as long as annual inflation stays below 1.3%, people receiving Social Security should be able to buy as much or more with their benefits in 2021 as they could in 2020.
However, if prices begin to rise faster than this, people living on Social Security or SSDI will suddenly find that their monthly payments can no longer buy as much as they used to. At best, their higher living expenses will leave them without cash left over for even small luxuries. At worst, they could be unable to make ends meet at all without some kind of emergency aid.
The best way to avoid ending up in this situation is not to rely on government benefits as your sole source of income. If you save for retirement throughout your working years, you’ll enter retirement with a cash cushion that can provide extra income to supplement your Social Security benefits.
Similarly, you can avoid becoming entirely dependent on SSDI by investing in disability insurance while you’re young through a company like Breeze. It will provide a payout if you ever become disabled.
If you’re already retired or on SSDI, your options are a bit more limited. If you find yourself facing higher expenses than your benefits can meet, you can look for costs you can cut to free up money in your budget. If that’s not enough, try looking for new sources of income to make ends meet, such as a post-retirement job or online earning opportunities.
If you’re currently in debt, inflation is your friend. When the dollar is losing value every year, the dollars you use to pay off your debt represent less actual purchasing power than they did when you first took out the loan.
For example, suppose it’s 1973, and you’ve just bought your first house with a 30-year fixed-rate mortgage. Let’s say the house cost $40,000, and your mortgage interest rate is 5%. That gives you a mortgage payment of about $215 per month.
The following year, inflation shoots up to 12%, and it stays above 6% for the next eight years. Each year, prices are rising by 6% or more, and your income is rising to match.
But your mortgage payment stays at that same $215 a month, year after year. You’re paying a smaller and smaller percentage of your income each year for housing, while the bank that loaned you the money is getting less and less value for its investment.
Banks know this, of course. When inflation is high, they usually raise their interest rates to make up for the declining value of the dollar. The Federal Reserve also tends to raise interest rates as a way to discourage borrowing, bring down consumer spending, and get inflation under control. Thus, high inflation today can mean higher interest rates and more expensive loans tomorrow.
So, if you know you’re going to need a loan in the near future, the best time to take it out is when inflation is on the way up. That way, you’ll be able to pay it off with cheaper dollars in the future. By contrast, if you wait, banks will probably raise their interest rates in response to inflation, and that loan will cost you more.
If inflation is good for borrowers, it’s bad for savers — especially those who are keeping their money in cash.
For instance, suppose you have $100 stashed away in a safe for emergencies. If inflation is currently at 4%, then by next year, that $100 will have only $96 worth of purchasing power. Over the course of five years at the same rate of inflation, your buying power will shrink to around $81.54.
Keeping your money in the bank is better, but not by much. The money in your savings account earns a little interest, but it won’t grow fast enough to keep up with inflation. Your bank will probably raise its interest rate eventually if inflation stays high, but that won’t make up for the value your savings have lost in the meantime.
Since savings don’t really pay off when inflation is high, it makes no sense to save more than you need to. This is a second reason why it makes sense to make purchases sooner rather than later when inflation is on the rise.
In addition to big purchases such as a car or a large appliance, you can spend early on everyday needs. For instance, you can fill up your car’s gas tank, stock your freezer, bring in fuel for the winter, and buy next year’s school wardrobe for your kids. Your dollars won’t hold onto their value sitting in the bank, so you might as well spend them now.
However, you can’t simply spend every dollar you have. Even when your savings are losing value, you still need some money set aside for emergencies, and you still need to save for retirement. For these essential savings, your best bet is to look for investments that offer a better real rate of return than a savings account.
For your emergency fund, stick to low-risk investments, such as money market accounts, certificates of deposit (CDs), or high-yield savings accounts at an online bank like GO2Bank. Even if they don’t pay enough interest to keep up with inflation entirely, they’ll preserve more of the value of your savings than an ordinary savings account.
For your retirement savings, you can afford to take more risk unless you’re close to retirement. Using the bulk of your retirement fund to invest in the stock market gives you the best chance of growing your money faster than inflation can take its value away.
There are two main kinds of investments: debt and equity. Debt is money you lend to other people and receive interest on. The money in your bank account is an example, since you’re technically lending it to the bank to lend out to others. Debt also includes corporate and municipal bonds — money lent to businesses or towns.
Equity, by contrast, is money that you put into someone else’s business venture in exchange for a share of the profits. Stocks are the best-known example. You can also put money directly into the business of a friend or family member or invest in other people’s businesses through crowdfunding.
As noted above, debt investments aren’t a great choice in an inflationary environment. If you’re earning a fixed interest rate of 3% per year and inflation is at 4% per year, your investment is actually losing value.
Equities are a much better choice. Because higher prices usually go along with higher wages and consumer demand, the economy tends to grow faster when prices are rising. This growth boosts stock prices, offering a chance for a good return.
According to CNBC, an investor who bought $1,000 worth of Apple stock in 1980, when inflation was at its peak, could have sold it in 2018 for around $340,000. By contrast, if you had simply kept $1,000 sitting in a safe since 1980, you would have the same $1,000 in 2018, but it would have lost about 65% of its value.
Of course, not all stocks do as well as Apple. Still, according to the Historical Investment Returns Calculator, even a buyer who put that $1,000 into an S&P 500 index fund would have ended up with $18,465 by 2018.
Another asset class that produces equity is equity real estate investment trusts (REITs). These funds buy, manage, and develop investment properties. Their money comes mostly from rents, which tend to rise along with other prices at times of rising inflation. They provide a steady source of income and also grow over time.
The bottom line: if you have money to invest in a period of inflation, your best bet is to put it into stocks (or mutual funds that invest in stocks) and other equities. They can gain and lose value in the short term, but they offer you the best chance for a real long-term return that beats inflation.
Inflation isn’t all good or all bad. It drives up prices and reduces the purchasing power of your savings, but it also drives up wages and typically boosts economic growth. That’s good for investors and for the economy as a whole.
However, that doesn’t mean inflation is both good and bad for everyone. In an inflationary environment, there are winners and losers. Investors, debtors, and wage earners — especially those who are in a good position to negotiate for a higher salary — come out ahead. Savers, creditors, and anyone living on a fixed income tend to fall behind.
If you want to make sure you’re on the winning side of the inflation game, take a lesson from businesses. They use inflation forecasts, published by the Federal Reserve and private sources like Kiplinger, to guide their short-term and long-term decisions. You can do the same thing with your personal finances.
For example, if you’re negotiating a salary at a time when inflation is projected to rise, make sure you factor in the rising cost of living when deciding how much to ask for. If you need to make a major purchase, such as a car, keep an eye on the trends for prices and interest rates to determine the best time to buy.
With inflation, as with most things related to personal finance, planning ahead is the key to coming out ahead in the long run.