What Causes Inflation?
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When trying to understand inflation, consider today’s economy. Learn how these sharp price increases can affect your daily living and your long-term investments. Discover the cause of current inflation and how to protect yourself financially.
By Helen Harris
Inflation: A continuous rise in prices usually attributed to an increase in the volume of money and credit relative to available goods and services.
The above definition is simple enough, but what does it mean relative to what’s going on in the economy right now?
You may realize that your everyday items are more expensive, and maybe you’re doing without certain things you once enjoyed.
What’s Happening with Inflation Now?
AP News reported that the prices of gas, food and most other goods and services soared in May, raising inflation to a new four-decade high. And currently, the annual inflation rate hovers at 7.7%.
Why is this? Tuan Nguyen, economist at RSM US LLP, explains that there are two major causes of inflation: Cost-push inflation (as costs to producers increase, higher costs are passed on to consumers) and demand-pull inflation (prices increase when aggregate demand exceeds the supply of available goods for long periods of time). The U.S. economy is currently experiencing both.
About one-third of the inflation right now is coming from the supply side due to the pandemic, said Nguyen. The demand aspect (roughly two-thirds of what is causing inflation) is a combination of government spending that increased during and after the pandemic and monetary policies where the Federal Reserve lowered interest rates to nearly 0% and increased its bond purchases. There is also demand coming from consumers and businesses because of increasing fiscal and monetary policies which made big spending and investing a lot easier.
The Basics of Inflation
In her LinkedIn Learning video, Cassandra Reed, wealth management advisor, explains that inflation is the rate at which the general level of prices for services and goods happens to keep rising. When inflation happens, the value of your dollar to purchase goods and services falls said Reed.
She provides the following example:
A cup of coffee in 1970 cost 25 cents, but over the years due to inflation, that same cup of coffee began to cost more and more.
That same cup of coffee in 2019 costs $1.59.
“You're paying more for the same thing, which means that you have lost purchasing power,” said Reed.
With this understanding of inflation in mind and an analogy of how it can affect a cup of coffee, you may be wondering how it will affect other aspects of your life and what you can expect.
How long will this increase in the prices of goods and services last? How will it go away — and what can you do in the meantime to keep yourself as financially stable as possible?
What To Expect, and What To Do, When Inflation Happens
Jane Barratt, chief advocacy officer of MX and champion of financial strength, states that one way to combat inflation is to increase your pay now so that it's above the rate of inflation and so you'll gain purchasing power.
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“Make sure you have a way to review your pay with your employer so that your salary can keep up with inflation,” said Barratt.
She says a second way to combat this challenging time is to put your savings to work is by investing.
“When you put your retirement savings to work and grow it through stocks, bonds or other investments, then you beat back the power of inflation,” said Barratt. “For example, the average long-term return from U.S. stock markets has been around 7%. If you can earn that kind of return on your savings, you'll certainly minimize the destructive force [of inflation].”
Reed emphasizes the importance of managing your investments during times of inflation and provides the following example to demonstrate how inflation erodes cash investments. But if that money is invested in the stock market, it can help offset inflation.
“Say you have $100. If you keep that cash and not invest it, 50 years from now, due to inflation, your $100 will only have a value of $75,” said Reed. “But what if you invest $100 into the stock market? The stock market has historically fought inflation by providing 10% returns in profit every year over the past century, beating the current inflation rate.”
Ultimately, Reed suggests thinking carefully about volatility and inflation when determining your investments. And if you find that challenging or are having trouble, it may be wise to consult with an accredited financial advisor to help you plan.
When it comes to big-ticket items, such as buying a new house, car or refinancing your home how should you proceed?
Nguyen recommends waiting a year or two — unless these items are urgent.
Why does he advise this? Because by then, it’s expected the U.S. economy will have inflation, interest rates and housing prices under control. But he also notes that saving is critical in the looming recession, as there will be inevitable job loss.
“When people are facing job loss, having saved enough money in advance is very important,” said Nguyen. “You want to have that emergency fund just in case something happens, as it could be a [difficult environment] to find a new job.”
How Does Inflation Go Away?
We all want lower prices, but in order for that to happen, there has to be a trade-off: That trade-off in this case is likely a recession.
“I think this is really about the trade-off between long-term cost and short-term pain,” said Nguyen. “If inflation gets out of control, the cost to the economy will be enormous. The government will be making a tough decision in that they will need to sacrifice short-term pain for the long-term benefit.”
But while no one can identify an exact date and time the inflation bubble will burst, Barratt stresses that you should protect yourself financially in the meantime. That often starts with carefully reviewing your lifestyle, budget and temporarily denying yourself things you would usually purchase.
“Price increases can be found everywhere, including your own spending,” said Barratt. “Lifestyle inflation is one of the biggest scourges of modern life. If you get a raise, don't just go and spend it. Make sure you target some of the savings and then some of that to your retirement accounts. Make sure you do what you can to fight inflation and protect your retirement savings. Grow your savings, increase your income and keep your spending in line. Those three things will reduce the damage that inflation can inflict.”
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What Causes Inflation?