When inflation pushes the costs of goods and services higher, it can impact more than just your short-term budget. Inflation can have ramifications for your investments and longer-term financial planning. Here, we'll dive into the concept of inflation, how it can affect interest rates, and how you can plan around it.
What does inflation mean?
Simply put, if the average price of products increases, that's inflation. Inflation measures the rising costs of goods and services over time. You might notice it in your daily life as you buy a gallon of milk or a meal out at your favorite restaurant.
The U.S. Bureau of Labor Statistics tracks hundreds of consumer goods across multiple regions using the Consumer Price Index (CPI) to gauge changes. Traditionally, inflation occurs at a rate of 2% or more per year, but the global pandemic has pushed inflation rates higher in the United States, with the bureau measuring an inflation rate higher than 7% at the end of 2021.
Over the past 50 years, the country's annual inflation rate has averaged out to 3.8%. Though the current inflation rate has climbed, inflation is part of the economic norm and should factor into planning your financial future.
How inflation impacts you personally
No one is spared from the effects of inflation. Here are some ways inflation can impact you:
- If your wages don't keep pace with inflation, you'll be spending more money out of pocket for the goods and services you use daily.
- If your investments don't return a higher yield than the inflation level, you'll lose money.
- As inflation increases, you may pay more taxes, whether through higher income taxes or sales tax on the rising costs of goods and services.
- If your wage increases outpace inflation, you may enjoy the benefits found in a fixed-price mortgage.
- If interest rates remain low during high inflation, it may offer an opportunity to refinance loans or debts.
How inflation can impact your investments
You can't control inflation, but it can still steer your financial planning, as inflation impacts assets differently.
- Savings: Cash tucked away under your mattress or locked away in a bank vault doesn't have the same buying power as it did 10, 20, or 50 years ago. The longer the cash sits, the more inflation impacts it. If you slide your extra money into a savings account, the low rate of return on those accounts may be less than the rate of inflation, meaning you're still losing value each year.
- Investments with set annual returns: A typical certificate of deposit, and many bonds, guarantee the same return each year. Due to inflation, that return will have a diminished value over time.
- Stocks: It's not easy to pinpoint inflation's impact on stocks. Some companies do well in times of high inflation, while others don't. The value of stocks is ever-shifting, and with so many stocks to choose from, inflation is just one factor to consider when investing in the market. Traditionally, stocks have outperformed inflation rates, but that is a generality and doesn't fit every year or everyone's investing experience.
- Annuities: Some annuities and bonds have a special index to compensate for inflation risk, yielding a return on your investment based on the inflation rate. Treasury inflation-protected securities (TIPS) and I-savings bonds offer some guaranteed protection against inflation, even if returns come relatively low.
- Real estate: While the price of your property may rise with inflation, it doesn't necessarily mean more money for you if you're looking to sell. Depending on other market factors, including interest rates, selling may become more complex. If you sell, the next property you want to purchase will likely have increased in value. If you're going to hold onto your property and the property's price is rising faster than inflation, you'll continue to gain value over time.
Investing during inflation
Ensuring you have a diversified portfolio of investments offers you some of the best protection against inflation fluctuations. And since inflation isn't the only factor when determining where to invest, the diversification of your portfolio must consider a range of personal needs. Flexibility is a key part of any plan; this allows you to adjust your investments as economic conditions shift.
Inflation and your life insurance
Those looking to purchase a term life policy may want to factor the average inflation rate into their decision.
The same amount of money that will cover your family's financial needs in the event you pass away today may not be adequate in 30 years if the inflation rate remains at its current level. Thus, it makes sense to factor in the inflation rate when determining the amount of your death benefit.
The information and content provided herein is for informational purposes only, and it is not to be considered legal, tax, investment, or financial advice, recommendation, or endorsement. You should consult with an attorney or other professional to determine what may be best for your individual needs.