?The Basics of Inflation
There is a lot of talk of inflation in the economic news lately. What does it mean?
Most of us understand the basic idea of inflation — things cost more than they used to. In fact, that is pretty close to the Webster’s definition. It is when prices go up. For example, I remember when I could put five dollars of gas in my little truck and drive for a week. Nowadays, five dollars gets me less than two gallons of diesel.
Inflation is at work.
Inflation has been pretty steady. Just a nice climb. In general, inflation has remained at an average of 3% for the past 30 years. We aren’t doing that bad — some countries have inflation above 1000% in one year.
Yes, sometimes it jumps, like in the 70’s. But in general, we are doing well.
Okay, what causes inflation?
Inflation can be caused by many factors. Increases in taxes and government fees can lead to inflation. Things that cost businesses especially cause inflation. When the cost of a business goes up, the product prices go up. When prices go up on products and services, your income goes down (you are spending more of it). You have to work harder and longer to afford the same things. Or hope that you get a cost of living adjustment.
Which causes the business costs to go up and it all starts over again.
Inflation also occurs when your personal taxes, property taxes and sales taxes increase. You ask for an increase in your wages. Then business costs go up and so on.
When things become rare, inflation can occur. The more demand on an item, the more expensive it becomes. For example, if there is a drought and wheat does poorly, the price of wheat goes up. This may cause the price of wheat products to go up.
If interest rates increase, inflation can also occur. The cost to borrow money goes up for businesses, increasing their cost and so on. However, higher interest rates also encourage people to save more and spend less, shortening demand and lowering prices on items.
For the most part, steady inflation is not seen on a day-to-day basis. You usually only see it when you look back. I remember that 85 cent gasoline in high school. But you made a lot less in your job as well.
Why is inflation important to the individual? Well, when you are planning for the long term, it can hurt you a bit.
If you are 30 year old, you are around 30 years from retirement. You plan to retire at 60 with a million dollars. That sounds like a lot of money.
It may not be.
Factor in 3% inflation for 30 years and your million dollars will only buy you around $400,000 worth of goods and services. If you live 20 years after retirement, that’s only $20,000 a year to live on.
Sixty percent of your money has gone to inflation. Can you live on that? You will need to save approximately $1.8 million and invest it at 5% after retirement in order to have the same amount of spending money as you do now.
So remember, inflation does really affect you. You should consider it when planning for the future. Other than that, there isn’t much you can do. But you must factor it in.
A quick way to factor in inflation is to subtract the 3% inflation rate from your assumed rate of return. For example, if you expect a 13% return on your investment, inflation takes it down to a 10% rate of return. This will give you a picture of the value of your investment.
There are investments out there than benefit from inflation, such as real estate and precious metals. Look into diversifying your portfolio into different types of assets, not just different types of stocks.
Inflation is simply a fact of life. By accounting for it, you are prepared to fight it in the future.