We’re living in super uncertain times right now and if you’re anything like me, you’re likely wondering about how all of this coronavirus and stimulus responses will not only impact the country, but also yourself specifically. One very likely outcome is that we might see some serious inflation and if so, what really are the effects of inflation?
What even is inflation? Inflation is one of the five very important terms to know in my Economy 101 blog as it will be the most impact you more often than not, so please checkout that blog for the other four terms as well!
Inflation is defined as “a general increase in prices and fall in the purchasing value of money.” In general, if prices are going up then your income needs to go up at the same amount for you to be able to purchase the same amount of goods, right? And your investments also need to go up the same amount for those to be the same as well.
Let me give an example:
- Your take-home pay is $50,000/year
- Your total expenses are $40,000/year
- Inflation for the year is 5%
Theoretically your expenses are now going to increase by 5%, right? Of course, some things like a mortgage, car or different loan might be locked into a certain rate, but your variable expenses like daycare, groceries and vacations are all going to increase. So, let’s say that half of your expenses are variable, so $20,000. That means that those $20,000 of expenses are likely now $21,000 ($20,000*1.05 = $21,000).
If you didn’t get a raise to cover that extra money, you’re now spending $41,000/year on expenses so your total “savings” has dropped from $10,000 to $9,000. Sure, that doesn’t seem like a big deal – only $1000, but it’s 10% of the amount you were saving!
To me, that is a big deal.
So how does inflation effect the economy as a whole?
Inflation can cause a motivation for people to spend their money now as it is worth more today than it will be tomorrow. I mean, it’s really all about the Time Value of Money, or TVM, which means that cash is king. And I say that in the sense that it’s ‘king’ to have your money in your hands, rather than in the hands of someone else.
I’m flashing back to the JG Wentworth commercials where they go, “It’s my money and I want it NOW!” “877-CASH-NOW”. Please don’t actually call them though lol, but the principle is that the quicker you get that money, the more time that you have to put it to work for you!
In general, a mild inflation rate, such as the 2% rate that the Federal Reserve targets, is a good thing! A 2% inflation rate is enough to get the public to truly value their money now and spend it when they get it. If their money is worth more now, the theory is that the more that you buy now, the less you have to buy in the future with a lower-valued dollar.
I know that this can sound confusing, but just try to break it down in simple terms – inflation means the dollar will be worth less than the future than it is now, so if you need to buy a television, would you rather buy a $1000 TV now or would you want to buy it in the future when the money is worth less? Buy it NOW!
Typically, when you start to see inflation rates rising, people will start to put their money into other currencies like gold or crypto. Andrew and Dave are HUGE fans of Bitcoin (I couldn’t lay the sarcasm on any thicker) so naturally, this seems like a reasonable place to invest (again, sarcasm).
Another impact to the economy is that you’ll see companies start to spend their money now and invest in any major capital expenditures that they might have. At the end of the day, a company is managing their money just as we are, but with a much larger sense of complexity, but if you’re going to buy any big purchases now to avoid the loss of purchasing power, don’t you think that they should as well? Of course!
I love investing in a company that I see spending their capital when it’s the most valuable for them. Doing so will only preserve earnings and theoretically benefit the value of all of their shareholders!
This also has a benefit on the economy simply from a job’s perspective. If inflation is rising and companies are continuing to spend their money on various expenditures, then they will be continuing to hire outside companies and contractors to do their work for them, supply them the products that they need and provide services that they need done. In short, inflation can help maintain, and even increase, the demand of jobs in the market!
Obviously, this is a great thing…in a vacuum. The danger of this is that it is somewhat of a never-ending cycle if it’s not controlled. This is exactly why the inflation rate needs to be controlled and why the Federal Reserve will target that 2% rate.
Another way that businesses will fund their capital expenditures is to borrow money now for those major expenditures that they are pursuing. If the cost of their debt is anything lower than the inflation rate, then it makes sense for them to borrow and invest it, right?
This is a very basic example, but if a company borrows $100K at a 2% APR and the inflation rate is 5%, then the company paid $2000 in interest for that first year, right? But, if they had just waited, they would now need $105,263 ($100K/.95). So, they’re better off bringing on the debt and paying for that expense now to avoid the loss of purchasing power in the future.
Of course, the banks aren’t stupid about this, and they will raise their interest rates on their loans to make sure that they are “meeting the market” in terms of offering rates that are not making them susceptible to being taken advantage of, unlike the situation that I just described.
All of these situations can have some MAJOR impacts on the economy, but let’s be honest – we’re all self-centered jerks that only care about ourselves! Of course, I am kidding, but how does inflation affect you and your own personal finance?
Well, the most obvious answer is with my LUNCH! Lol.
Do you remember when Subway used to offer $5 footlongs for ALL FOOTLONGS? Yeah, me too. Now, my favorite sub, the Subway Club, isn’t quite $5 anymore…
In fact, it’s not even close! $8 from $5 is a huge increase of 75%! Now, instead of a Subway Club, it’s called a Subwa. Get it? Another bad joke – my specialty! That is called inflation my friend. Now I can’t afford the chips and a drink that they make sound so enticing!
You have just lost your purchasing power of your Subway! I’m sorry that I am still using this same example but I immediately thought about this when talking about inflation. It was an entire slogan and promotion, solely based on price and a dumb jingle, and now the only sub you can buy for $5 is that crappy sub called a Cold Cut Trio. I think the trio is bread, baloney and crap! Sorry. I like Subway.
Of course, inflation will affect you much more than just what you eat in terms of paying for major housing renovations, memberships to a gym or a country club, haircuts, groceries, and literally almost every other way possible!
It’s obvious of the #1 impact that inflation has to you, as a consumer, but what are some of the other impacts?
Retirement Planning – This is really just a long-term look of the previous situation that I outlined for you. Just as your money is worth less tomorrow than it is today, it’s worth way less in 30 years! I know this is extreme, but if you planned to only eat a $5 footlong for lunch and dinner, for 365 days/year, that would’ve cost you $3,650 when the promotion rolled out but it would cost you over $5,832 now! If you’re not planning an extra $2K in your food budget, that could really throw off your expenses!
This is really just an analogy, but think about how it could impact your healthcare, groceries, flights to visit your kids and grandkids, etc., for many years in the future! Planning for the future with the expenses of today is foolish – you have to make sure that you’re planning for the future with numbers that are from the future!
“But Andy, I’m not Marty McFly – how do I know the future?”
Well, as with anything else, my recommendation is to look at history and then use a conservative look and continuously adapt! So, what has inflation in the US done over time?
There’s a really nice graph from Statista that shows the inflation rates over the course of recent history, shown below:
As you can see, the range is really in the 2 – 3% range, so I like to use 2.5% as a target. Since the Fed targets 2% inflation, I like to aim for something a little bit more conservative. If you want to go even more conservative, do it! It’s much better to plan for the worst and hope for the best then plan for the best and run out of money when you’re 70. I think that’s a famous saying but don’t quote me on it.
All I will do then is go to a future inflation calculator (my preference is Vertex42) and then input the values needed:
I’m imagining that I currently need $1.5 million, as I mentioned, and will retire in 30 years, and inflation is 2.5%. So, I essentially need to plan to have nearly $3.15 million in 30 years. Seems easy, right? No. Not at all. But again, better than aiming for $1.5 million and needing $3.15 million…
If you were just aiming for $1.5 million in 30 years, can you see how badly you might be in trouble? It could have a HUGE negative effect. To me, this honestly might be an even bigger impact than your day-to-day spending, although it is all truly correlated.
So, now that you have a great grasp on how retirement can affect you both in the short and long-term, how can you defend against it?
The #1 way is to plan. Plan for inflation and then develop a strategy. You need to anticipate your future needs and save for that rather than what you need today. So, I would personally do the following:
- Loans – try to take advantage of a fixed APR rate that might not change with inflation. For instance, if your mortgage is a fixed rate, it’s not going to increase as inflation changes, so you are continuing to pay the same amount for your house even though your money is worth less. In other words, you’re freeing up cash flow by protecting this loan from inflation.
- Invest as much early as you can – the more that you can invest now, the better. Not only will it save you with compound interest but it will also just give you that much more time to outpace inflation.
- Maximize the value of your non-invested money – $1 that is just sitting in cash is now worth $.95 if inflation is 5%. You earned nothing on that dollar and now you can buy less with it. Put that money in a high yield savings account or even a CD. It’s ok if it has low risk if you’re using it for an emergency fund or a short-term purchase, but you need to make sure you’re maximizing its value.
So, at the end of the day, is inflation a good or a bad thing? Well, as with almost anything else in life – it depends on your mentality and your preparation. To me, I think a 2% inflation is great, but I also know how to play my cards when things are not normal, and let’s be honest, when is life ever normal?