Inflation occurs as demand for goods and services grows. As the total money supply in an economy rises, there is likely to be more demand for goods and services from consumers. As more people buy more goods, sellers hike their prices.
Inflation is caused by other factors, many of them temporary and limited in their scope.
How do you measure the effect of inflation on your savings? The government measures it for you and publishes the results regularly. The Consumer Price Index (CPI) tracks the prices of a variety of consumer goods and services, including transportation, medical care, and housing. The index is published monthly.
Believe it or not, inflation can be too low. In the wake of the 2008 financial crisis and the great recession, the central banks in the U.S., Japan, and Europe were worried that inflation could, essentially, go below zero, meaning deflation, or falling prices. In fact, the U.S. did experience deflation in house prices lasting several years in many markets.
During the worst of the crisis, the Federal Reserve targeted a 2% annual growth in inflation to return the economy to health. The bank initiated various stimulus measures that were intended to boost the economy and encourage job creation, therefore putting more money in consumer’s hands.
Back in the late 1970s, the Fed was fighting double-digit rates of inflation. Economists will probably never stop debating whether the Fed’s measures, in the 1970s or the 2000s, were the right ones.
How to Safeguard Your Income. If you are a retiree who gets a Social Security payment, you may see an increase in your monthly check from one year to the next, as the government adjusts the payment based on the cost of living as measured by the Consumer Price Index.
However, that increase requires approval by Congress. An increase of 2.8% was approved for 2019, and an increase of 2% for 2018. But the increase was .3% for 2017, and zero for 2016. Those numbers were based on the Consumer Price Index, but advocates for retirees argued that price categories that most affect the elderly, such as health costs, rose more rapidly than the overall index.
How to Safeguard Your Savings. The primary way to beat the effect of inflation is to invest your savings for a better return than you can get in money market accounts or savings accounts.
Investing in virtually anything else inevitably involves greater risk that an FDIC-insured account. But you can choose investments that have a level of risk that you can tolerate.
For example, retirees might want to consider Treasury Inflation-Protected Securities, or TIPS. These securities adjust the interest payouts you get based on changes in the CPI, and the principal payment you get back also will be adjusted for inflation. Even if prices go down over your investment period, you will at least get back your original principal.
Returns on stock investments generally tend to beat inflation. Investors who want to avoid the volatility associated with individual stocks might opt for mutual funds, which are professionally managed and aim to provide a good return over time.
A mutual fund that follows a passive indexing approach might be even better since it is not dependent on the stock-picking abilities of any particular fund manager. The stock market overall tends to go up over time. You will also pay less in fees with an indexing approach.
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The Bottom Line. Inflation tends to cut into a consumer’s purchasing power over time. Fortunately, there are ways of you can preserve the purchasing power of your savings. That means investing, but keeping your level of risk moderate.