Inflation reduces the purchasing power of currency units, causing prices of services and goods to increase over time.
It’s a financial word that says you’ll have to pay extra to fill your gas tank, purchase a gallon of milk, or get a haircut. In other words, it raises your living expenses.
When you compare the value of the dollar today to the worth of the dollar in the past, you’ll notice that inflation in the United States has lowered the value of the dollar.
As a result, your money buys less as prices grow. Given this, it has the potential to reduce your level of living over some time.
The Inflation Rate, What Does It Entail?
The inflation rate is simply the percentage difference in prices over some time, usually a month or sometimes a year. The percentage difference indicates how quickly services prices increased during the period in question.
For instance, if the yearly inflation rate for a gallon of gas is about 2%, gas prices will be at least 2% higher the preceding year. This shows that a gallon of gas at $2 this year will be priced at $2.04 the following year.
The inflation rate is a crucial component of the country’s misery index, which is an important financial measure that aids in determining the financial wellbeing of the citizens.
The unemployment rate is the other factor. When the misery index rises above 10%, it shows that citizens are experiencing either soaring inflation, recession, or both.
On the other hand, hyperinflation happens when the inflation rate surpasses 50% in a month.
What Are the Factors That Cause Inflation?
- Demand-pull inflation
When the demand for services or products exceeds the normal supply, customers are willing to pay a higher price for the product.
The second and less prevalent reason is inflation. This is a supply-side constraint when the supply rate is limited while the demand rate is not. This once happened due to Hurricane Katrina’s damage to gas delivery pipes. The gasoline demand did not change in this scenario, but supply limits pushed prices to $5 per gallon.
- Built-in Inflation
This considers people’s inflation projections in the future: Labor expects salary increases to keep up with price increases, but higher wages raise the cost of production, which raises the price of goods and services again.
When this cycle of effect and cause continues, there will be an emergence of a wage-price spiral.
- Inflation Control by Central Banks
Central banks use monetary policy worldwide to avert inflation and deflation. In the United States, the Federal Reserve aspires for a year-over-year inflation rate of 2%.
The FOMC announced on August 27, 2020, that it would allow a target inflation rate of greater than 2% if it helps ensure maximum employment.
It continues to aim for 2% inflation over time but is willing to accept higher rates if inflation has remained low for a long time, as the October 2021 rate shows.
The Fed utilizes the core inflation rate, which excludes the cost of gasoline and food. These prices are determined by commodity traders and are far too volatile to be considered.
How Can One Effectively Manage Inflation as a Middle-Class Earner?
If at all possible, the most effective strategy to insulate yourself from inflation is to raise your earning capacity and income. For example, a 5% annual raise or a promotion that earns you a 20% increase will make inflation a lot less meaningful. If this doesn’t pose as an option for you or operating a fixed income, you’ll have to check out alternative options.
- Series I Bonds
Series I bonds have a fixed rate of return guaranteed for the bond’s duration. They’re also impacted by a variable rate tied to the CPI and resets in November and May twice a year.
The bond’s return is a combination of its fixed rate and the variable rate in force at the time. 18 Visit the Treasury Department’s Savings Bond Calculator to calculate the return on each bond.
- Supply-side policies
Policies aimed at improving competitiveness and efficiency while also lowering long-term expenses.
- Fiscal policy
A higher marginal tax rate on income could lower consumer spending, demand, and inflationary pressures.
- Wage limits
Attempting to keep wages under control might theoretically assist in lessening inflationary pressures. However, it has only been used a few times since the 1970s.
- Investing in the stock market is a strategy to reserve your savings.
Over time, it has produced about 10% of your investments. However, it’s unclear if the strategy will do well in the future, and there’s also the chance of investing in the stock market. Before making any financial decisions that may influence your overall financial goals, consult with a financial planner.
Consider two instruments available from the US Treasury if you want a more secure strategy to protect yourself from inflation.
- TIPS (Treasury Inflated Protected Securities) pays a fixed interest rate.
The government increases the principal twice a year in reaction to changes in the Consumer Price Index (CPI), as given by the Federal Bureau of Labor Statistics monthly.
This means that as inflation rises, the bond’s value rises as well. Although the interest rate does not change, the percentage is applied to a bigger principal, resulting in a greater cash payment.
TIPS performs well during periods of inflation but not so well during periods of deflation or stability. They do not outperform a well-diversified portfolio that includes stocks over the long term.