Inflation is the concept that the cost of goods and services increases over time. What a dollar can purchase today is going to be more than a dollar will be able to purchase twenty years from now. The purchasing power of that dollar diminishes over time as the price of goods and services increases. Many people think of inflation as having a negative impact because they must spend more to purchase the same items. However, inflation can serve as a healthy component in an economy’s growth.
Inflation is not the increase in price of a single good or service, but rather of a broader basket of goods and services. In the U.S., the standard used to measure inflation is the Consumer Price Index (CPI). The CPI is a measure that examines the weighted average of a basket of consumer goods and services. The basket of goods is intended to mimic the common products and services purchased by U.S. consumers and includes items such as food, energy, clothing, housing, medical care, education, communication, and recreation. The weighted average of these goods and services produces a percentage which is reported as the rate of inflation.
While economists often disagree about the exact numbers, it is commonly believed that inflation in the 5%-6% range and below is healthy for an economy, and inflation above the 9%-10% range is harmful to the economy.
Here are some of the common effects that inflation can have on consumers and the economy:
- Purchasing Power Diminishes. As already mentioned, when inflation raises prices, the purchasing power of a dollar diminishes. Consumers will have to spend more money to purchase the same items. Those hit hardest are the ones holding cash or who are on a fixed income that is not inflation-adjusted annually. Over time, their purchasing power can be significantly impacted.
- Spending Increases. As consumers and businesses fear that the value of their dollar will diminish, they attempt to spend that money before it does. Increased spending by consumers and businesses positively impacts the economy.
- Interest Rates Rise. However, as consumers and businesses spend more, more money enters the money supply, and inflation continues to rise. To curb run-away inflation, the Fed will then increase interest rates. Higher interest rates mean higher payments when borrowing money. This causes consumers and businesses to reconsider taking out loans to make major purchases. This means less is being spent and there is less money in the money supply. This slows the rate of inflation.
- Existing Borrowers Benefit. Borrowers who already took out debt, like a fixed-rate mortgage, will likely benefit from inflation. The value of their monthly mortgage payments will decrease over time. A fixed payment of $2,500 per month on a 30-year mortgage will decrease in value over the lifetime of that loan. Assuming their income is growing along with inflation, it will feel like they are paying less over time. However, borrowers who are in variable debt products will likely see their payments increase over time so that the value of those payments are keeping up with inflation.
- Investors Target Stocks. One way to offset rising prices is to purchase stock in the companies benefiting from receiving more money due to higher prices. As the companies earn more for the products they make, their stock prices will increase along with it. The value of an investor’s money will increase as the stock price increases which will offset some of the impact of inflation.
Many consumers feel the immediate impact of inflation and interpret it as a negative. Spending more on an item you are used to buying never feels great. However, modest inflation does serve an important role in the overall economy. As long as the rate of inflation stays within healthy ranges, it is something to take advantage of rather than fear.
Jeff Witz, CFP® welcomes readers’ questions. He can be reached at 800-883-8555 or at witz@mediqus.com.
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