Wendy Bennett: How does inflation affect your money?
The inflation rate has made headline news in the last few months, reaching 9.06% in June — its highest level in 40 years. Inflation is defined as a continuous increase in the price of goods and services over time. As inflation reaches higher levels, it can quickly decrease your purchasing power, so your dollar doesn’t stretch as far.
In the United States, inflation is tracked through the Consumer Price Index (CPI), which is a collection of goods/services that represents what the average American buys on a weekly basis. Price changes to these items is measured over time to determine the rate of inflation. The goal of our federal government is to sustain an annual increase of around 2% which is considered a stable and healthy economy. Although the amount of goods that $1 can buy slowly decreases every year under this goal, you can remain on an even keel if the economy is growing and your income is adjusting to such inflationary increases. Moderate inflation encourages individuals to spend or invest money today, rather than stuff it under the mattress and watch its value diminish.
To put the latest inflation reading into perspective, let’s examine how inflation erodes your purchasing power by using the “Rule of 72.” According to this rule, if you divide 72 by the annual inflation rate, you can approximate how quickly higher prices (for food, energy, rent and other household budget items) will cut the value of your money in half. At the 9.06% annual inflation rate posted in June, your purchasing power theoretically would be cut in half in just under 8 years if inflation continued at the current rate.
Several factors can increase the rate of inflation: excess demand, scarce supply, rising housing prices, low unemployment (viewed as higher wages due to competition for employees) and more money being printed and put into circulation (think of all the recent individual and business stimulus monies associated with the pandemic). Having experienced all of these factors over the past couple years, it’s not surprising that inflation has reared its ugly head.
With savings account interest rates barely above 0%, inflation erodes the value of your liquid cash. However, in the case of your emergency fund, savings is not designed to grow your wealth, but rather is meant to provide a financial cushion should you need it. Beyond your emergency fund, you can look for ways to hedge against inflation, such as equity investments that can generate returns in excess of inflation over the long term. It is wise to curb spending when possible during times of high inflation, especially for big-ticket purchases.
Inflation is one of the greatest threats to accumulation and preservation of wealth. As stated by billionaire investor Warren Buffett, “Arithmetic makes it plain that inflation is a far more devastating tax than anything that has been enacted by our legislature. The inflation tax has a fantastic ability to simply consume capital.”
Wendy Bennett is a senior financial adviser at Bennett Associates Wealth Management in Butler.
