If you follow financial news at all — or even just the nightly news — chances are you've frequently heard experts and economists discussing the economy's inflation rate. While they can make it sound like something to worry about, they don't usually take time to explain the basics, including how inflation can affect your efforts to save and invest. To help straighten things out, we're explaining the potential impact of inflation on your financial plans.
What Is Inflation?
Inflation is when average prices in the entire country go up. In other words, the buying power of an individual dollar decreases when the price of everything has increased. For example, pretend it costs $100 to buy a bicycle today, and the current inflation rate is 2 percent: Next year, the price of the bicycle will be $102, assuming that price increases in step with inflation.
In 1950, a single dollar went a lot further, as the average house only cost $7,354 and a year of tuition at the University of Pennsylvania was only $600. As the years went by, wages and prices have increased to push the entire price level up, so the value of a single dollar has gone down. That's inflation in action.
According to the Bureau of Labor Statistics, the inflation rate from June 2017 to June 2018 was about 2.9 percent, but this rate can swing up and down depending on the state of the economy.
How Can It Impact Savings?
Over time, inflation can reduce the value of your savings, because prices typically go up in the future. This is most noticeable with cash. If you keep $10,000 under your bed, that money may not be able to buy as much 20 years into the future. While you haven't actually lost money, you end up with a smaller net worth because inflation eats into your purchasing power.
When you keep your money in the bank, you may earn interest, which balances out some of the effects of inflation. When inflation is high, banks typically pay higher interest rates. But once again, your savings may not grow fast enough to completely offset the inflation loss.
How Can It Impact Investments?
The impact of inflation on investments depends on the investment type. For investments with a set annual return, like regular bonds or bank certificates of deposit, inflation can hurt performance — since you earn the same interest payment each year, it can cut into your earnings. If you receive a payment of $100 per year, for instance, that payment would be worth less and less each year given inflation.
For stocks, inflation can have a mixed impact. Inflation is typically high when the economy is strong. Companies may be selling more, which could help their share price. However, companies will also pay more for wages and raw materials, which hurts their value. Whether inflation will help or hurt a stock can depend on the performance of the company behind it.
On the other hand, precious metals like gold historically do well when inflation is high. As the value of the dollar goes down, it costs more dollars to buy the same amount of gold.
Finally, there are some investments that are indexed for inflation risk. They earn more when inflation goes up and less when inflation goes down, so your total earnings are more stable. Some bonds and annuities offer this feature for an additional cost.
How Can You Plan for Inflation?
Inflation is one reason many people don't put all their money in the bank — over time, that inflation can erode the value of those savings. For that reason, some prefer to keep some of their money in potentially higher-growth investments like stocks or mutual funds, because on average these investments earn more per year than the inflation rate (although they also carry a risk of lower earnings or loss).
You may also want to consider inflation risk as you figure out what kinds of investments to have in your portfolio. Fixed investments, like bonds or fixed annuities, can be adversely affected by inflation. To diversify, some investors choose to add gold or inflation-indexed investments to their portfolios.
Inflation is a market force that is impossible to completely avoid. But by planning for it and putting a strong investment strategy in place, you might be able to help minimize the impact of inflation on your savings and long-term financial plans.