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What is Inflation?

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Inflation is quite a bit more than a fancy word that reminds us to check our tire pressure. In the world of money, inflation is just a term economists use for the rising cost of goods and services over time. Another way to think of it is the decrease in purchasing power of your money over time. Either way, it’s something we all live with, to a certain extent, every day of our lives. It’s the natural result of economic growth and relatively loose monetary policy. And it’s generally more desirable than the alternative—deflation. But that’s for another time…

Inflation is often thrown around as a dirty word in finance circles. And while out-of-control inflation, or “hyperinflation,” can certainly be a very bad thing, moderate or low inflation is generally desirable for the overall economy. In fact, it’s actually the goal of our Federal Reserve to maintain a moderate (and stable) level of inflation, along with low unemployment. In other words, the Fed’s very existence is tied to the goal of “steadily” (the key word here) devaluing the US dollar over time. That might sound a bit odd, but inflation is a VERY complicated beast that, if tamed in a calculated manner, can unleash a lot of benefits to society as a whole.

If you think about it, rising prices most often result from a combination of high demand for a good or service and rising incomes. Both of those result from economic growth and wealth creation. Inflation can also come from the often misconstrued and oversimplified concept of “money printing” or increasing the money supply, which the Federal Reserve has been doing a lot of in recent years. That said, inflation in the US has remained at or below 2% per year for the better part of a decade now despite an historic expansion of our money supply over that time, to the surprise of a lot of very smart people. 

 

What does inflation mean for me?

For those that hold a significant portion of their wealth in cash or are unable to invest or benefit from rising wages for various personal and/or socioeconomic reasons, inflation means their cost of living is rising faster than their income and overall wealth. If the purchasing power of every dollar they earn is falling, their overall financial situation is likely in decline as well. This can make a very difficult situation much worse. 

On the other hand, steady/moderate inflation can be somewhat beneficial for anyone owning real assets or investments, like stocks. Because of the general sense of fear the word inflation often instills in people, talk of inflation hedges (ways to mitigate the effects of inflation) become commonplace in times where markets and/or economists are expecting the rate of inflation to ramp up. According to the conclusion of this article, investing in a properly diversified portfolio consisting mainly of stocks, is one of the best ways to reduce the negative wealth effects of inflation on your overall net worth. Your home can also be an inflation hedge, especially if you finance the purchase with today’s historically low fixed interest rates.

Inflation is complex. And while the long-term effects can be devastating for some, those that embrace its inevitability can actually benefit from understanding how to invest appropriately and incorporate it into their own personal financial planning.


 

The information is provided for discussion purposes only and should not be considered as advice for your investments. Past performance is no guarantee of future results. Please consult an investment advisor before you invest.

 

Published on June 23, 2021