What would happen if the money
in your bank account bought less this year than last? Would you change your
spending habits? Would you spend more time thinking about how to get a better
deal or look for sale prices on items that you frequently buy? Would you
stop buying certain items or change your outlook on what is a “need” and what
is a “want”?
The cost of everyday goods just
keep going up. The average price of gas in Baltimore, at the time of writing
this article, is $4.84 per gallon. Eggs have jumped in price from $1.67
per dozen in 2021 to about $2.74 in 2022. And a gallon of milk will set you
back about $4.33. Overall, inflation in May hit 8.3%, but the year-over-year
increase specifically for food items rose 9.4%. Chicken is up 16.4%. Eggs are up
22.6%. Margarine is up 23.5%. Why is this happening? Why would your money be
worth less this year than last year? You would need to understand
inflation in order to answer this question.
What Is Inflation?
Inflation affects everyone in
the economy: workers, businesses, and individuals, especially those on fixed
incomes, as well as borrowers and lenders. What is inflation? Inflation is an
overall increase in the prices of goods or services in an economy. Over time,
monetary currency loses its value, and it does not have as much purchasing
power as it once did.
When inflation is high,
consumers will spend more time shopping looking for the best deal for their
purchases. Manufacturing companies raise their prices as it becomes costlier to
produce their products. And stores that sell those products must raise their
prices, in turn, due to the increased prices from manufacturers. Individuals
who are on a fixed income from social security will have a more difficult time
as their monthly income will buy less. They may even have to cut back on
essentials, such as food, medicines, and utilities.
Inflation not only affects
consumer spending habits, the cost of goods at the manufacturing level, and the
price of merchandise in retail stores; it also affects interest rates. When
inflation is high, the Federal Reserve Bank typically raises interest rates to
slow the economy and bring inflation down. When inflation is too low, the
Federal Reserve Bank typically lowers interest rates to stimulate the economy
and move inflation higher.
Understanding inflation is
crucial to investing because inflation can cause unpredictability in the
financial markets, reduce the value of investment returns, and result in a
decline in stock market valuations. Other possible effects of high inflation
include lower wages for workers and a drop in home prices.
Why does inflation occur?
Although no one can pinpoint its exact causes, there are two main reasons: first
is an increase in demand or a decrease in supply, and second is as a result of
financial and governmental policies.
Types of Inflation
There are four main types of
inflation, and they are categorized by their speed.
Creeping inflation occurs when prices rise
by 3% or less per year. The Federal Reserve Bank supports the premise that when
prices increase by 2% or less, it benefits economic growth. Mild inflation,
less than 2% per year, has consumers expecting prices to keep creeping steadily
upwards, which boosts demands for products or services. This, in turn, has
consumers buying goods or services to beat higher future prices. That dynamic
drives economic expansion. For this reason, the Federal Reserve Bank sets 2% as
its target inflation rate.
Walking inflation occurs when prices rise between
3% and 10% per year. This is the situation we find ourselves in now, and it is
harmful to the economy. Can you guess why? During walking inflation,
individuals purchase more than they need to avoid tomorrow’s much higher
prices. This increased demand puts suppliers at a disadvantage as they cannot
keep up with the consumers’ buying. As a result, two things happen: Common
goods, such as toilet paper or baby formula, are priced out of reach for most
people, and wages cannot keep up with the prices on the supermarket shelves.
Galloping inflation occurs when inflation rises to
more than 10%. This causes havoc on individuals and in the economy. During
galloping inflation, money loses value so quickly that an employee’s income
cannot keep up with prices. It’s the same with businesses. Businesses cannot
keep up with rising production costs and raw material prices. This, in turn, leads
to foreign investors avoiding putting money into the economy. Then, the economy
then does not get the capital it so desperately needs.
Hyperinflation occurs when prices rise by more
than 50% per month. Hyperinflation is rare and most often happens when a
government prints money to pay for wars. The classic example is what happened
in Germany after World War I. The last time the United States experienced
hyperinflation was during the Civil War back in the 1860s.
Inflation Miscellany
The
Federal Reserve Bank uses the core inflation rate to guide it in setting monetary
policy. The core inflation rate measures the price change of goods and services
– everything except for food and energy, which are very
volatile. Higher gas costs increase the price of food and anything else that
has high transportation costs. In addition, individuals, couples, and families
use more gas on vacation. So the Federal Reserve Bank doesn’t want to adjust
interest rates when gas prices go up; instead, it uses the core inflation rate
to guide it when setting monetary policies.
Deflation is the opposite of
inflation. Deflation is when prices fall. Although it sounds wonderful to have
prices fall, deflation can actually lead to a recession or depression.
Wage inflation occurs when workers’ pay rises
more rapidly than the cost of living. Wage inflation occurs in three different
situations: first, when there is a shortage of workers. A worker shortage can
occur when unemployment is below 4%. The second situation is when labor unions
negotiate higher wages. The third situation is when workers control their pay.
How can workers control their pay? CEOs, chief executive officers, of a
corporation can sit on the corporate board of their own business and decide how
much they want to get paid!
Inflation and your Investments
To summarize, inflation raises
prices, so that an individual must pay more for the same goods or services. But
what happens to an individual’s savings, pensions, retirement funds, and
Treasury notes? What about assets such as real estate or collectibles? Usually,
the higher the rate of inflation, the lower the value of one’s investments.
We can take retirement funds as
an example. Inflation can be bad for your retirement planning as the target
amount to be saved for retirement must keep increasing to pay for the same
quality of life you are used to. In other words, with inflation, your
retirement savings will buy less as time goes on. And stocks? Usually, as
inflation rises, stock prices fall, and when inflation falls, stock prices
rise.
So is inflation good for you
and your family, or is inflation bad? It really depends. Individuals are
definitely feeling the sticker shock of high food and gas prices. If you are on
a fixed income or you are owed money, inflation can wreak havoc on your
finances. But if you owe money on your home, you are now repaying your mortgage
loan with money that is worth less than it was worth when you borrowed it. This
means that inflation actually works in your favor.
Want ideas on how to save money?
Feel free to email me for simple and practical suggestions.
Rivka Resnik has developed the
Living Smarter Personal Finance Curriculum that is used in high schools across
the country. If you would like a specific topic addressed or for more
information on Living Smarter Jewish Coaching or the Kosher Money Podcast,
please contact info@livingsmarterjewish.org.
