Open any business journal or turn on a news station and you’ll probably hear about inflation. There’s a lot of talk — and concern — about rising inflation and the impact of inflation on savings. From January 2021 to 2022, the cost of consumer goods rose 7.5% — the highest one-year increase since 1982.
What does increased inflation mean for you? As inflation goes up and prices rise, your money doesn’t go as far when buying things.
This article will help answer your questions about how inflation works, where it comes from, and how it affects the value of money. We’ll also look at the effect of inflation on savings and investments and give you ways to plan for rising inflation.
What is inflation?
The basic definition of inflation is the increase of prices over a period of time. It’s usually represented as a percentage. Let’s say the average price of a used car went from $10,000 to $10,500 over a year. The inflation rate would be 5%.
You can measure inflation for specific goods or services — like the car example above — or a broader category like energy costs. The consumer price index (CPI) is the most common measurement in the US.
The CPI is a record of the change in price for various sets of goods and services, known as the market basket. The Bureau of Labor Statistics collects actual price data from real consumers for CPI.
How does inflation happen?
Since inflation is a rise in the costs of goods and services, it can happen for several reasons. Anything that could affect the prices of consumer goods could potentially trigger inflation. However, there are two main causes of inflation:
- Demand-pull inflation
- Cost-push inflation
The third type of inflation — built-in inflation — can happen as an after-effect of the other two.
Demand-pull inflation
Demand-pull inflation is basic supply and demand. It happens when consumers’ demand for products or services outpaces their production. This leads to a limited supply of the product or service. In turn, consumers are more willing to pay a higher price for it. The price increases as long as demand is high and supply is low.
Demand-pull is the most common reason for inflation. It can happen anytime there is more money for consumers to spend. A thriving economy with increased wages can lead to demand-pull inflation. As workers’ salaries increase, they start to spend more, and the overall supply decreases.
Demand-pull inflation example
We can look at this on a small scale using an example of a single workplace. Let’s say there’s an on-site cafeteria that sells hamburgers for $5. Most employees don’t buy a hamburger because they want to save their wages.
However, the employer decides to raise everyone’s pay. Now, the employees have more money and decide to treat themselves to lunch. The cafeteria can’t keep up with the demand and raise the price to $8.
Cost-push inflation
Demand-pull inflation is due to increased consumers wanting a limited supply of a product. Cost-push inflation, on the other hand, comes from increased costs of production.
As the cost to create a product goes up, so does the price. Manufacturers and retailers have to factor in the increased cost of making the product into the final price.
Cost-push inflation example
By far the most common example of cost-push inflation is crude oil prices. As the cost of oil rises, every industry that relies on it has to pay more to manufacture its products. The manufacturers pass these costs onto retailers, who pass them to consumers.
You’ve probably noticed cost-push inflation at the gas pump — as crude oil prices go up, so do gasoline prices.
Built-in inflation
Built-in inflation is when workers demand higher wages as a result of increased costs of goods. It’s a direct result of either demand-pull or cost-push inflation. As consumer goods get more expensive, workers ask for higher salaries to cover their costs of living. This can lead to a cycle of increasing wages and costs of goods.
However, built-in inflation relies on workers’ perceptions that prices are going to continue to increase. Prices should be steady if the cause of inflation is addressed. When prices stop climbing, built-in inflation tends to fall off.
Before we dive into how inflation impacts your savings, let's talk about how it affects that value of money.
How does inflation affect the value of money?
So, how does inflation affect the value of money anyway? Well, inflation happens when prices rise. It doesn’t decrease the literal value of your money. Rising inflation won’t turn your $1 bill into $0.50. However, it could increase the cost of a household good from $1 to $2.
Higher prices mean that dollar won’t buy as much as it did before inflation because of decreased purchasing power.
What is decreased purchasing power?
Purchasing power is how many goods or services you can buy with a certain amount of currency, such as dollars. Increased inflation leads to decreased purchasing power. As the price of goods goes up, your dollar doesn’t buy as much as it did before.
Decreased purchasing power example
The price of a car one year ago was $10,000. Rising inflation causes the price to increase to $11,000 this year. Your purchasing power has gone down because you need an additional $1,000 to buy the car.
How does inflation affect a household?
What about your monthly expenses? How does inflation affect a household? The cost of everyday goods and services went up from January 2021 to January 2022. According to the Consumer Price Index, prices increased for every category:
- Cereals and bakery products increased 6.8%
- Meats, poultry, fish, and eggs increased 12.2%
- Fruits and vegetables went up 5.6%
- Electricity costs went up 10.7%
- Apparel increased 5.3%
- Used cars and truck prices increased 40.5%
How do these increased costs affect your family? Higher costs can strain your budget. After paying for necessities like groceries and gas, you’ll have less money left over for other things. This could make it harder to pay down debt or save money.
Example of the effect of inflation on a household
Katie’s monthly income is $3,000. Her mortgage and insurance costs are $2,000. She has a minimum payment of $300 on her debts. She typically spends $500 on groceries, fuel, and other goods like clothes. This leaves her with $200 to put toward savings, investments, and additional debt payments.
Inflation causes the cost of groceries and other goods to go up. Now, Katie has to pay around $650 per month for these consumer goods. She’s left with only $50 to put into savings or toward her debt.
How does inflation affect savings accounts?
Inflation has the most notable impact on savings. Most savings accounts let you earn interest on your balance. If you leave your money in the account, you accrue interest and grow your savings.
During inflation, your savings interest rate needs to keep pace with inflation. If your savings rate falls behind the current rate of inflation, your buying power goes down and that's what causes the impact of inflation on savings.
Impact of inflation on savings example
Here is an example of the impact of inflation on savings accounts. You have a savings account that earns 1% interest annually. You have $1,000 in the account. In a year, you’ll earn $10 in interest. To keep the buying power of your interest earnings, inflation needs to stay 1% or less. If the inflation rate is higher, your money loses purchasing power.
How does inflation affect investments?
So, now you know the impact of inflation on savings, but how does inflation affect investments? Most investments perform better than cash when inflation is going up. However, a lot of different factors can change how an investment will perform during inflation.
Stocks
Stocks are unpredictable assets. This is even more apparent during inflation. That’s because inflation can cause some stocks to soar in value while others drop.
Why are stocks unpredictable during inflation? Each company’s response to inflation can change its valuation.
Let’s say Company A raises prices on their products by 10% without a drop in demand. They manage to keep their production and labor costs relatively the same as before inflation. Their stock will likely go up as profits outpace expenses.
Company B, on the other hand, raised prices by 10% but also saw a 15% increase in production costs. As the profits and value of the company decrease, their share price could go down.
Real estate
Real estate investments often perform well during inflation. Property prices tend to increase along with inflation. This means your property could be worth more than when you bought or invested in it.
For example, you bought a home for $200,000 and have $100,000 left on the mortgage. Property values have gone up due to inflation. Your home is now worth $250,000. However, you still only owe $100,000. Your equity has increased from $100,000 to $150,000.
Commodities
Commodity prices usually go up with inflation. Commodity prices can even be an indicator of inflation. Most goods are made using raw materials that are commodities, such as crude oil or metals. If commodity prices go up, the goods made from them will likely go up as well.
Fixed income investments
Unlike other investments, fixed-income investments usually perform worse during inflation. Fixed income investments include assets like certificates of deposit (CDs) or corporate bonds. These products give you a guaranteed rate of return on your investment.
When inflation is low, fixed-income investments are a good way to get guaranteed returns. However, the fixed interest rate may not be enough to outpace inflation. As inflation goes up, your interest rate stays the same.
Fixed income investments work a lot like savings accounts during inflation. Say you have a CD with a fixed annual return of 2%. If inflation rises above 2%, the money earned by your CD will lose buying power.
Treasury Inflation-Protected Securities (TIPS)
Luckily, certain fixed-income investments help protect you from inflation. Treasury Inflation-Protected Securities (TIPS) are government bonds that adjust with inflation. As inflation goes up, the Treasury adjusts the principal — or original amount — of your bond.
For example, you purchase a TIPS bond worth $1,000 with a 2% rate of return. You get $20 in interest payments. The next year, inflation increases by 5%. To protect your buying power, the Treasury adjusts your investment to $1,050. You still get 2% returns, but the higher principal means you make $21 instead of $20.
How to plan for the impact of inflation on savings and investments!
The effect of inflation on savings can make you lose buying power. However, it is an important part of the economy. Being prepared for rising inflation can help you protect your assets and buying power. Check out a few ways you can safeguard your financials when inflation starts to go up.
1. Diversify your portfolio
Using a mix of investments is one of the best ways to protect yourself from inflation. A diverse portfolio could include some stocks, bonds, and real property like commodities. Remember, however, that diversifying your portfolio doesn’t guarantee a return. Any investments can be volatile and have the potential to lose value.
2. Choose inflation-resistant stocks
Plan to do your research when choosing stocks for your portfolio. For example, you can look at historical prices during previous periods of inflation. Does the company consistently increase in value when inflation is high? Or, does the share price drop whenever inflation rises?
This can help you determine if a stock is potentially a good fit for your portfolio.
3. Maintain an emergency fund
Should you pull your money out of your savings account when inflation is rising? No — it’s important to keep some easy-to-access cash in case of an emergency. While the effect of inflation on savings can cause this money to lose buying power, it lets you cover emergency expenses.
If you keep all of your money in investments, you’ll have to liquidate them before you can access the money. This could take several business days — making it difficult to pay for a sudden expense. Aim to keep at least 3-6 months’ expenses in cash savings.
4. Watch your wages
Many employers offer a standard “cost of living” increase for employees. This yearly raise helps combat inflation — when it’s at a reasonable level. When inflation is higher than normal, cost of living increases may not be enough to cover actual increased costs. That means you earn more but still lose buying power.
You can make sure your current wages are covering inflation by comparing them to your costs of living. If regular costs like gas or groceries are unaffordable because of inflation, you may need to increase your wages. This could be done by getting a second job, starting a side hustle, or asking for a raise at work.
Tips for asking for a raise
You shouldn’t use inflation as the sole reason for a raise. Use these tips instead to approach your boss and ask for a raise:
- Come prepared with salary data for your position.
- Be open to a bonus or other incentive instead of a salary increase.
- Ask for the high end of the salary range so you have room to negotiate.
- Use performance metrics to explain why you deserve a raise. Do you go above and beyond your job requirements? Have you worked a lot of overtime or taken on new duties?
Plan ahead for the impact of inflation on savings and investments!
So, that's the effect of inflation on savings and investments! While it fluctuates up and down, inflation is still a part of the economy. It’s best to be prepared in case inflation increases.
Check out your current finances and look for ways to protect them from inflation. Safeguarding your money against inflation helps keep cash flowing even when prices start to go up.
You can also learn just how inflation impacts business in this article!