Inflation: what is it and why should I care?

Inflation: what is it and why should I care?

Have you noticed that prices go up each year? At the hairdressers or ice cream parlor? Perhaps you haven’t, but pay attention next time to what your banana costs. Why does this increase happen consistently, year-over-year?

Over time prices tend to rise in part due to increased demand (want) for goods and services, in comparison with the supply. This increase in price is known as inflation. As inflation increases more money is required to purchase the same products or services. Over the last 20 years, our population and economy has grown tremendously. Naturally, prices, income, and inflation have grown as well. Today’s prices are 768.16% higher than they were in 1960. That means it takes $8.68 to buy what $1 did back in 1960[2].

We often fail to notice the effects of inflation because, like growing plants, it happens slowly in small amounts. However, over decades, the effect is significant. Surprisingly, for most of the last 60 years, inflation has hovered around 2% to 3% annually. It is, therefore, important, as you can imagine, for wages to raise accordingly. To keep up with inflation, salaries tend to rise at a similar pace, called a “cost of living” increase.

But what about COVID? Many Americans like you, at the start of the pandemic, were worried about their health and their jobs. You might have heard about the possibility ‘of a deep recession” but one that never really came. Two outcomes came of this panic; some hoarded money, amassing recording saving levels, while others continued spending… In many cases, spending was supported by government transfers, government borrowing that will eventually need to be paid back by taxpayers. At the same time supply of goods has been disrupted, meaning less stuff is available.

Continued spending, caused car and housing prices to increase (maybe you noticed?). Many Financial advisers and economists say some consumers feel defeated, but we don’t want you to be one of them…

Here are four things you can do to shield yourself from the impact of inflation.

1. Invest

Over time inflation decreases what you can buy with $1. This means, keeping your money as cash means you run the risk of not having enough money to fund your retirement due to inflation. Therefore, investing money is an advisable way to protect yourself from risk. For example, putting money into a retirement fund (Roth IRA or 401 K) or investing your money in a diversified portfolio of cash, bonds, and stocks will make it more probable that your investments keep up with inflation. While investing in the stock market does involve the risk of loss, there are also risks of not investing, inflation being one of them.

2. Know What Your Retirement Spending Will Be

It might sound crazy to think about retirement now if you are still in your 20s, but considering what you have just learned about inflation, it is necessary…no? The best defense is a good offense: For example, you may wish to retire in 15 years, you believe your basic living expenses to be $50,000 per year today and you expect to live 30 years after retirement. Naturally you would think you would need to accumulate $1.5 million in savings. However, this does not consider inflation. At a 3% rate of inflation, your living expenses in your first year of retirement would actually be around $78,000. You will need to save much more than $1.5 million and / or at a higher rate of investment return to keep up with inflation in retirement. Having a clear sense of your basic retirement living expenses and the inflation rate will help you better estimate how much you will need to save.

3. Consider Your Cost of Living In Retirement

The less expensive your lifestyle in retirement, the better you will be able to absorb the impact of inflation. If you live in the San Francisco Bay Area, you already know that the cost of living here is one of the highest in the United States. Therefore, you will need to save considerably more to fund your retirement. Moving to an area where the cost of living is lower means your retirement savings will go farther. If you love the Bay area, and can’t imagine living anywhere else when you retire, then you will have to considerably increasing your savings rate and / or reducing your retirement spending to make sure your retirement funds will last.

4. Reduce Your Debt

To maximize your comfort in retirement, reduce or eliminate consumer debt (credit card, auto loans, personal loans, etc.) by the time you retire. If you have a high mortgage payment, consider paying off your mortgage or downsizing to a smaller home. The higher your debt, the higher your retirement expenses will be, and the less capable you will be to weather the impact of inflation in retirement.

Just remember Grandma’s story; A gallon of gas cost $1.14, a dozen eggs cost $1.01, and a gallon of milk cost $2.80[3]. In 2019, a gallon of gas cost $3.98, a dozen eggs cost $3.22, and a gallon of milk cost $4.16[4]. Imagine where inflation will take prices over the next 30 years? To make sure your money works for you and works faster than inflation, remain fully invested in a diversified portfolio, manage your expenses, and minimize your debt. In these uncertain times especially, we might feel helpless and that we can’t control inflation, but we can control our actions and how we plan for its effects.