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What Is Inflation Definition – Causes of Inflation Rate and How to Fight the Effects

By Pat S

inflation toilet paperIn 1980 in the United States – just over 30 years ago – a new home in this country cost an average of $76,000, and the median income was $17,710 per year. Compare that to 2011, when even after the recent recession, the median home price stood at $139,000, and median household income was $50,233 per year according to the US Census Bureau.

Why the vast difference in prices? One word: Inflation. Like aging or weight gain, the effects of inflation are both gradual and profound. Inflation creeps up on us over time, and as we continue our normal spending and consumption habits, the almost imperceptible increase of consumer prices doesn’t seem to make a huge difference in our day to day finances – which means it is all too often vastly underestimated.

But the effects of inflation are huge. And it doesn’t just affect areas like our salaries and the cost of purchasing a new home. Inflation hits us from every angle. Food prices go up, transportation prices increase, gas prices rise, and the cost of various other goods and services skyrocket over time. All of these factors make it absolutely essential that you account for the huge impacts that inflation can have on your long-term savings and ability to fund your golden years of retirement.

How can you do that? Let’s first get an understanding of what inflation is and the general causes of it. We’ll then discuss how inflation can impact your investing strategy and style in order to make thoughtful and conservative long-term financial decisions.

What Is Inflation?

To put it simply, inflation is the long term rise in the prices of goods and services caused by the devaluation of currency. While there are advantages to inflation which I will discuss later in this article, I want to first focus on some of the negative aspects of inflation.

Inflationary problems arise when we experience unexpected inflation which is not adequately matched by a rise in people’s incomes. If incomes do not increase along with the prices of goods, everyone’s purchasing power has been effectively reduced, which can in turn lead to a slowing or stagnant economy. Moreover, excessive inflation can also wreak havoc on retirement savings as it reduces the purchasing power of the money that savers and investors have squirreled away.

Causes of Inflation

So what exactly causes inflation in an economy? There is not a single, agreed-upon answer, but there are a variety of theories, all of which play some role in inflation:

1. The Money Supply

Inflation is primarily caused by an increase in the money supply that outpaces economic growth.

Ever since industrialized nations moved away from the gold standard during the past century, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. When the Federal Reserve decides to put more money into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. As a result, this devaluation will force prices to rise due to the fact that each unit of currency is now worth less.

One way of looking at the money supply effect on inflation is the same way collectors value items. The rarer a specific item is, the more valuable it must be. The same logic works for currency; the less currency there is in the money supply, the more valuable that currency will be. When a government decides to print new currency, they essentially water down the value of the money already in circulation. A more macroeconomic way of looking at the negative effects of an increased money supply is that there will be more dollars chasing the same amount of goods in an economy, which will inevitably lead to increased demand and therefore higher prices.

2. The National Debt

We all know that high national debt in the U.S. is a bad thing, but did you know that it can actually drive inflation to higher levels over time? The reason for this is that as a country’s debt increases, the government has two options: they can either raise taxes or print more money to pay off the debt.

A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate. Alternatively, should the government choose the latter option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices (as discussed above).

3. Demand-Pull Effect

The demand-pull effect states that as wages increase within an economic system (often the case in a growing economy with low unemployment), people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand.

An example would be a huge increase in consumer demand for a product or service that the public determines to be cheap. For instance, when hourly wages increase, many people may determine to undertake home improvement projects. This increased demand for home improvement goods and services will result in price increases by house-painters, electricians, and other general contractors in order to offset the increased demand. This will in turn drive up prices across the board.

4. Cost-Push Effect

Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices.

A simple example would be an increase in milk prices, which would undoubtedly drive up the price of a cappuccino at your local Starbucks since each cup of coffee is now more expensive for Starbucks to make.

5. Exchange Rates

Inflation can be made worse by our increasing exposure to foreign marketplaces. In America, we function on a basis of the value of the dollar. On a day-to-day basis, we as consumers may not care what the exchange rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are one of the most important factors in determining our rate of inflation.

When the exchange rate suffers such that the U.S. currency has become less valuable relative to foreign currency, this makes foreign commodities and goods more expensive to American consumers while simultaneously making U.S. goods, services, and exports cheaper to consumers overseas.

This exchange rate differential between our economy and that of our trade partners can stimulate the sales and profitability of American corporations by increasing their profitability and competitiveness in overseas markets. But it also has the simultaneous effect of making imported goods (which make up the majority of consumer products in America), more expensive to consumers in the United States.

The Good Aspects of Inflation

In a fact that is surprising to most people, economists generally argue that some inflation is a good thing. A healthy rate of inflation is considered to be approximately 2-3% per year. The goal is for inflation (which is measured by the Consumer Price Index, or CPI) to outpace the growth of the underlying economy (measured by Gross Domestic Product, or GDP) by a small amount per year.

A healthy rate of inflation is considered a positive because it results in increasing wages and corporate profitability and keeps capital flowing in a presumably growing economy. As long as things are moving in relative unison, inflation will not be detrimental.

Another way of looking at small amounts of inflation is that it encourages consumption. For example, if you wanted to buy a specific item, and knew that the price of it would rise by 2-3% in a year, you would be encouraged to buy it now. Thus, inflation can encourage consumption which can in turn further stimulate the economy and create more jobs.

money bill inflation

10 Strategies to Combat Inflation’s Effects on Your Retirement

The single most important consideration that inflation introduces into your financial planning process is: Factoring for inflation, how much will I really need to retire?

What is your savings goal? Many people have set an arbitrary goal of $1 million to retire. But how much will a $1 million be worth when you retire?

If you are planning to retire in 2050, a rate of inflation approximating 3% per year will result in $1 million dollars having the purchasing power of $325,000 of today’s dollars. How long will $325,000 carry you? If your current cost of living is around $50,000 a year, you can see that $1 million will only carry you through about 6 years in retirement assuming you do not have supplemental sources of income.

So, what can be done to combat inflation’s detrimental effects on savings and adjust your portfolio for inflation? Contrary to public belief or opinion, we aren’t helpless in combating the role inflation can play in our lives. Many strategies can act as a hedge against inflation, but these techniques must be employed strategically and effectively in order to take advantage of their benefits. Ten of the best ways to combat inflation are as follows:

1. Spend money on long-term investments.
We all love to save. But when it comes to long-term investments, sometimes spending money now can allow you to benefit from inflation down the road. As an example, let’s say you are looking to take out a mortgage to purchase a home and economists project significant inflation over the next 50 years. When you consider you can repay the mortgage down the line with inflated dollars that are worth less than they are now, then you are using inflation to your benefit. Other areas where you can take advantage of inflation include home improvement projects, capital expenditures for a business, or other major investments.

2. Invest in commodities.
Commodities, like oil, have an inherent worth that is resilient to inflation. Unlike money, commodities will always remain in demand and can act as an excellent hedge against inflation. For most of us, however, purchasing commodities in the open marketplace is probably too much of a daunting task. In that case, you can consider commodity-based Exchange Traded Funds (ETFs) which offer the liquidity of stocks with the inflation hedging power of commodity investment. Just be careful of and watch out for the problems of ETFs.

3. Invest in gold and precious metals.
Gold, silver, and other precious metals, like commodities, have an inherent value that allows them to remain immune to inflation. In fact, gold used to be the preferred form of currency before the move to paper currency took place. With that said, even precious metals are liable to being a part of speculative bubbles.

4. Invest in real estate.
Real estate has also historically offered an inflationary hedge. The old saying goes: “land is the one thing they aren’t making any more of.” Investing in real estate provides a real asset. In addition, rental property can offer the landlord the option of increasing rent prices over time to keep pace with inflation. Plus, there’s the added alternative of the ability to sell the real assets in the open market for what normally amounts to a return that generally keeps pace with or outstrips inflation. However, just like with precious metals, we all know that real estate bubbles can and do exist.

5. Consider TIPS.
Treasury Inflation Protected Securities (TIPS) are guaranteed to return your original investment along with whatever inflation was during the lifetime of the TIPS. But TIPS do not offer the opportunity for significant capital appreciation, and therefore should only make up a portion of your personal investment portfolio allocation.

6. Stick with equities.
Although investing in bonds may feel safer, historically, bonds have failed to outpace inflation, and have at times been crushed during hyper-inflationary periods. Over the long term, the only source of inflation-beating returns has been the stock market. Equities have historically beat bonds because of the ability of corporations to pass price increases along to their consumers, resulting in higher income and returns for both the company and its investors.

7. Consider dividend-paying stocks.
Exhaustive research by Wharton School of Business economist Jeremy Siegel reveals that large cap, dividend paying stocks have provided an inflation-adjusted 7% per year return in every period greater than 20 years since 1800. If you have the investment risk tolerance for the volatility and a time horizon of greater than 20 years until retirement, consider dividend-paying securities. Dividend stocks offer a hedge against inflation because dividends normally increase on an annual basis at a rate which outpaces that of inflation. This almost guarantees stock price appreciation at a similar pace, while offering the further benefit of compounding when dividends are reinvested.

8. Save More.
The fact is that you are probably going to need a lot more money for retirement than you think you will. There are two ways to get to your new benchmark: Save more, or invest more aggressively. Saving more is probably the easiest and most proactive thing you can do to ensure your ability to fund a comfortable retirement. If you are saving $250 a month, could you save $500 a month if you ate out a few less times and carpooled to work? Chances are, you could and this will help protect you from future inflation. See some of these planning strategies for how much to save for retirement based on age.

9. Invest in collectibles.
Who would have believed the return on investment you could have gotten from the purchase of a Mark McGwire rookie card during his first year in Major League Baseball, or a Limited-Edition G.I. Joe in its original packaging? Buying and selling collectibles can actually offer great inflation-adjusted returns, while also being a fun and interesting hobby.

10. Become a patron of the arts.
The strategic acquisition of photography, paintings, sculptures and other art can often provide inflation-beating returns, though certainly not always. My suggestion would be to find the best of both worlds, a valuable piece of fine art that you truly appreciate and will not be in a hurry to sell.

Final Word

Like it or not, inflation is real. Ignoring the effects that inflation can and will have on your long-term savings is probably one of the biggest mistakes that many investors make. Understanding the detrimental causes and effects of inflation is the first step to making long-term decisions to mitigate the risks. But the next step is taking action. Consider the ten tips above to help you overcome the devastating effects inflation can have on your future retirement.

What actions are you taking to ensure that your portfolio returns outpace inflation? Share your best tips in the comments below!

(photo credit: Shutterstock)

Pat S
Pat S is an active duty military officer. On his off time he enjoys working out, reading, writing and spending time with his dog. Pat became interested in personal finance after several costly mistakes early in his military career that could have been avoided by a basic understanding of personal finance.

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Comments

  • http://www.moneyistheroot.com Justin @ MoneyIsTheRoot

    Very thorough article. It’s nice to see someone explain the effects of inflation. We can’t just let out money sit in savings accounts and CD’s. Collectibles are a bit too risky for me, but I absolutely agree on dividend stocks. ADP is a great example of a dividend that meets inflation, and then the price gains outpace it…

  • Mart

    I have been keeping an eye on information on inflation. Money is a very interesting subject. I was searching the internet like always and found this website if anyone wants to check it out.

    http://www.thegoldstandardnow.org/about/jacques-rueff

  • http://www.compoundingreturns.com Pat S

    Thank you both for the comments! I enjoyed doing a little more research into inflationary causes and hedging strategies myself.

  • Brody

    Pat, very matter of fact explanation regarding inflation.

    However, I think the bigger point is missed- Inflation is a hidden tax, imposed upon the American people, on purpose, by the U.S. Government, through the actions of the Federal Reserve. You hit upon this point above, under 1. Money Supply.

    Every American should read “The Creature from Jekyll Island”, by E. Griffin. Pretty eye-opening, and I hope more people read this book, and understand where we are heading, on a national and global economic level.

  • http://twitter.com/BrokersWiki BrokersWiki

    Buy gold, this is the best protection against inflation.

  • atem

    v.good

  • kisaakye doreen

    what are the effects of inflation

  • Angela

    Thanks Pat! I was working on a paper on inflation and was having a hard time finding articles that I could understand since I’m new to this stuff. After reading your article, I really can say that I have a better understanding.

  • Israr Khan

    Buy property is the best protection against the inflation

  • Providence Maduka

    Impressive work. Simple, understandable, and reliable. Hope to see more of your articles.

  • quedow

    well done…….this z much reliable n effective

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