Explaining Inflation’s Effect on Your Wallet

You may have noticed that you’re spending a little more than you usually do at the grocery store.

That slight uptick in prices can be explained by inflation. Inflation is the rate at which prices for goods and services increase over a period of time. One way inflation is measured is with something called the Consumer Price Index (CPI), which shows the percentage change in prices paid by urban consumers on goods and services. The CPI is produced by the Department of Labor’s Bureau of Labor Statistics (BLS).

Inflation currently stands at 5.3%, according to the September, 2021 CPI. That’s a threefold increase compared to 2020. The increase in prices is thought to be a result of changes to the economy caused by the Covid-19 pandemic, but inflation can happen for a variety of reasons.    

Let’s look at what leads to inflation and what it means for you and other consumers. 

What causes inflation?

Since the beginning of the pandemic, inflation has contributed to rising prices across numerous industries, which has sent prices up for consumers. For example, a shortage of semiconductors, used to power many technologies in cars, as well as an increased demand for vehicles, has sent new car prices higher. That demand for cars is also pushing the price of used cars up, and more road travel has also meant more expensive gas. Food prices and eating out costs are also on the rise. Restaurants are paying workers more amid a labor shortage, and that’s making prices for customers higher.  

The two biggest types of inflation are called demand-pull inflation and cost-push inflation. Remember the rules of supply and demand: supply is the amount of product while demand is the number of people who want the product. Demand-pull inflation occurs when demand increases to a point where supply can’t keep up, increasing prices. When demand slows down, so do price increases. 

Cost-push inflation happens when the price of raw materials or the cost of workers’ wages goes up, and businesses pass those costs on to consumers as price increases. This phenomenon has contributed to the current rate of inflation. The price of lumber, for example, has pushed up house construction prices during the pandemic. With more houses being built, the cost of lumber increased by more than five times in the 14 months following March 2020. 

The Federal Reserve and inflation

Government policy can also have an impact. A country’s central bank can control how much money is available, thereby affecting supply. The central bank of the U.S., known as the Federal Reserve, or the Fed, can affect inflation by increasing or decreasing the money supply. The more money is available, the less each dollar is worth, which can cause inflation. For example, some economists have suggested that the influx of cash into the economy from recent stimulus bills has contributed to pushing prices up. 

The Fed also sets something called the federal funds rate, the central bank’s benchmark interest rate. Changes to the federal funds rate lead to changes in interest rates throughout the economy. So when the Fed reduces that rate, borrowing money for things like a house and on credit cards can become cheaper. However, cheaper loans can also cause costs to go up as demand increases. The Fed also uses this rate to fight inflation, by increasing the rate and making borrowing more expensive. 

A degree of inflation is thought to be normal and healthy because it means the economy is functioning properly. The Fed tries to maintain roughly a 2% inflation rate, and when it goes significantly higher, the central bank may raise the federal funds rate to achieve its target rate. 

However, at the start of the pandemic, the Fed lowered that rate to almost zero percent to stimulate the economy with so-called cheap money in the form of low-interest loans.  The Fed has kept the rate there, and has been hesitant to increase it, since the economy is still recovering. And that may be keeping inflation higher than normal.

What inflation means for consumers 

Inflation has real implications for your wallet. Generally speaking, inflation can reduce the value of your money as costs of goods and services go up. It can also decrease the value of savings in a traditional bank account, especially while interest rates remain low, as they are now. And if you invest in bonds, inflation can also affect the value of that investment, since interest payments on bonds are fixed. Over time, with inflation, those payments will be worth less.

In the current inflationary period, energy prices have experienced a 25% increase year over year, according to the BLS. Within energy, fuel oil prices increased by more than a third, and gasoline prices by more than 42%. Meanwhile, natural gas prices have gone up by 21.1%. 

Source: BLS

At the grocery store, prices have also risen 3%. The three areas that have experienced the biggest jump in prices are meat, poultry, eggs, and fish (8%), fruits and vegetables (2.3%), and nonalcoholic beverages, and beverage materials (2%). At restaurants and other out-of-home dining experiences, costs have reportedly risen 4.7%.

How consumers can combat inflation

Investing in stocks and exchange-traded funds (ETFs) is one way to try to combat the effects of inflation. While you’re not guaranteed a return on any investment, investing your money is a way to try and stay ahead of inflation—hopefully, your return will outpace the rate of inflation.

If the inflation rate is currently 2%, for a simple example, and your portfolio had a return of 5%, your real return would be 3%.

For comparison, the average annual return for the S&P 500 index over the past 10 years has been more than 13%. If you were to invest your money into a fund that tracks that index, your money would stay way ahead of the inflation rate.

Remember, however, that all investing involves risk. In order to protect yourself and your money against risk, it’s important to follow the Stash Way, by investing regularly in a diversified portfolio of stocks, bonds, and ETFs.