Even though the inflation rate has eased from the June 2022 high of 9.1% to a current rate of 3.1%, we continue to feel inflation’s effect on our budget. What is most important is how we react to it. Effective strategies can turn inflation from a foe into a catalyst for financial growth and stability.
Inflation & the Economy
While we know that inflation is the gradual rise in the price of goods and services, the resulting impact of it is that our dollar doesn’t go as far. Inflation happens when demand is high and supply is low. During the pandemic, we held off on vacations, didn’t need to purchase clothes and had fewer events to attend. As restrictions eased, there was a lot of pent up energy and savings that people were looking to spend. Couple this with post-pandemic supply chain issues, and the result was high demand with low availability. This propelled inflation up to a rate that hadn’t been seen since the early eighties!
While some amount of inflation in the economy can be healthy to drive economic growth, inflation causes dollars to be worth less than they were in the past. As a result, people have less purchasing power. This means one of two things: 1) we need to increase our incomes to maintain the standard of living we’re used to or 2) tighten our spending.
Inflation & Your Money
While stocks are often impacted by inflation in the short term, “safe” bonds haven’t escaped the impacts of inflation either. Bonds are fixed-income securities and are essentially loans you make to governments or companies; bonds that offer a fixed interest rate are exposed to interest rate risk. As interest rates rise, the values of existing fixed-interest bonds decline.
To understand this concept, first think of the impact of inflation on a shopping cart of food that you buy at the supermarket. If the items in the cart cost $100 this year, inflation of 3.1% means those same items cost $103.10 a year later.
Then suppose that during that same year, you have a short-term bond fund with a yield of 1%. Over the year, the value of a $100 investment rises to $101 before taxes. On paper, you made 1%, but in real-world money, the fund actually lost $2.10 worth of purchasing power. The “real” return was a loss of 2.1%.
This also applies to cash. We may think we are “keeping it safe” by not exposing it to the stock market; once we factor in the impact of inflation, we are actually losing money by keeping it in cash. Therefore, inflation affects our purchasing power and can erode our savings.
Inflation & the Stock Market
In 2022 we experienced the perfect storm of both stocks and bonds declining at the same time.
Even though inflation has moderated from its 2022 peak, it remains a concern as it impacts markets and investor strategies. While we should expect some continued volatility, if the funds are invested for the long-term, we would expect double digit returns over time, rather than seeing our money erode each year from inflation.
If we take a step back from it all, from 1926-2023, a portfolio of 100% stocks has provided an average annual return of 10.5% and a portfolio of 100% bonds returned 5.4%
Protect Your Money from Inflation
To help minimize the impact of inflation, here are steps you can take to protect the purchasing power of your dollars.
- Increase your income. Is there a side hustle that you can start? Have you asked your boss for a raise if you think it is warranted?
- Trim your expenses. To minimize the impact of inflation, review your spending and identify areas to reduce or eliminate completely. Start by taking a look at your subscriptions: if you are no longer using any of your streaming, newspaper or fitness services, now is a good time to cancel them. It will free up money to invest so you can be better prepared for the future.
- Prioritize High-Interest Debts: Focus on paying off high-interest debts first, as these erode your wealth the fastest due to compounding interest.
- Wait to pay off low-interest debt. Paying off debt is usually good, but you may want to hold off on making extra payments if you have low- interest debt. Your debt actually becomes less expensive due to inflation. The extra money may be better used for other purposes—like paying off higher-interest loans or investing it.
- Invest your money. Inflation causes your savings to be worth less over time. While you want to keep enough money in cash for your emergency fund (about 3-6 months of expenses), any excess cash that isn’t needed in the near term is best to be invested to hedge against inflation.
Long Term Success
Taking some of these small steps to help protect your funds from being eroded can go a long way to helping contribute to your long term success.