Inflation: How to Beat it with Smart Financial Planning
How to Outpace Inflation
This is a guest post from Shaun Connell, author of Learn Financial Planning, a series of free, comprehensive financial planning tutorials.
It’s hard to watch the news or keep up with anything financial without hearing about inflation, deflation and our current money supply. Understanding inflation is essential to the basics of personal finance. It’s not just an economic concept it impacts you every day, and is only of the biggest obstacles your investments will face.
Inflation is when your dollar loses it’s buying power. Inflation is when is takes more currency to buy the same amount of stuff.
Take penny candy, for example. I still remember when I could buy a small piece of candy for a penny. Now, I haven’t seen penny candy in years. This doesn’t mean the candy disappeared. No, you can still buy the candy I used to buy… now it just costs ten cents or more. This means one of two things:
- Candy is becoming more valuable, OR
- Our currency is becoming less valuable
The second is, by far, the most important concept to understand. That’s because the price of almost everything has gone up over the past few decades. Overall, our money is becoming worth less and less. The penny isn’t what it used to be.
But why? What does this mean for us?
What Causes Inflation?
One of the most basic principles of economics is how the law of supply and demand affects prices. If there’s a bunch of something, it’s usually not valuable. If there’s not much of something, it’s usually pretty valuable. To simplify the concept: the more that’s available, the less it’s worth.
For example, a truckload of gold is worth more than a truckload of sand. It’s all about what economists call “scarcity.”
Remember, our money isn’t inherently worth anything. It only has worth because people think it does, and because it’s relatively scarce. There aren’t millions of dollars under every bed. Money simply represents the real material wealth that others own. If there’s more paper and less wealth, then the ratio of dollars to value goes down, the dollars are worthless.
So what causes inflation? Though there are an incredible number of complicated smaller causes, the biggest cause is simple: the government decides to print more money. The actual material wealth in the economy isn’t changing. The government doesn’t make money; the government just prints money.
Inflation is what happens when there’s more “money” being created than there is worth being added. In other words, if the government prints 100 trillion new dollars, and our real GDP only grows about 10 trillion dollars, we’ll be seeing roughly 90 trillion dollars diluting the value of other dollars. That’s inflation.
But why should we care about inflation?
How Inflation Hurts You
Inflation slowly erodes the value of your wealth. The average yearly inflation is about 3.43%. This means that every single year, the cash you have is worth 3.43% less. That might not sound like much, but it’s simply mindboggling:
- Fact: Investments really make less than you think. If you make an average of 6% return in your investments every year, you’re actually only making about 2.6% per year after factoring into account inflation.
- Fact: Investment fees are eating into your returns. If you are paying anything more than $5 for your trades, you’re getting hammered.
- Fact: For most people, a “raise” breaks even, maybe. If you get a 10% raise every three years, you aren’t actually getting a raise at all. You’re actually living on 3% and 6% less for two years preceding your raise after factoring into account inflation.
Inflation especially affects the people in the lower income rungs. Right now you can’t get away from hearing about inflation and deflation — it’s all over the news. Why? And what should you do?
What is Deflation?
Right now, we’re actually seeing a major amount of deflation, caused by the recession and low oil prices. This means that your money actually has a bit more buying power than usual.
But don’t get comfortable. We’re about to see record levels of inflation in the next few months and/or years. Just consider the following facts:
- Fact: More Fed loans are given, increasing inflation. All over the news, you can see reports that the Federal Reserve is lowering interest rates down to nearly 0%. This means the Federal Reserve (the people who print money) will be giving out more “loans.” A “loan” is when we give money that doesn’t yet exist for banks to loan out. The lower the interest rate, the more loans are given out, the more money is printed.
- Fact: We’re already printing a lot, increasing inflation. In the past few months, the Federal Reserve has already printed more money than the last 19 years combined.
- Fact: Spending increases printing, increasing inflation. Over the past few months, Bush has spent over a trillion dollars to help the economy. Obama has already pledged at least another trillion towards his economic stimulus alone. Spending several trillion dollars is a surefire way of increasing inflation.
I’m not saying the world is going to end — just that inflation is going to start again, and soon. We’re seeing deflation right now, which means one thing: This is the perfect time to get prepared.
How to Beat the Future Inflation
Understanding inflation isn’t enough; you have to be willing to take actions to “beat” inflation. Though there are many tactics, the four tips below are simply a must for a rational financial plan:
- Stock Up. Remember, as we’ve talked about before, we’re currently in the middle of deflation. That means that items that will be increasing in costs in just a few months to a year are actually much, much cheaper. So stock up. Buy bigger boxes and value packs. This is usually still a good idea, but right now it makes even more sense.
- Precious Metals. Usually, I’m not a big fan of precious metals like gold and silver, and encourage their purchase only for the sake of diversity and financial security. But due to the recession, the price of gold looks good. Precious metals are also a great “crisis hedge” in the sense that during times of crisis, investors often flee back to precious metals.
- Save, Save, Save. As mentioned before, a high-interest savings account will allow you to just break even. But right now, with deflation, you’ll actually be making even more. Remember, deflation is the opposite of inflation, which means for every 1% of deflation, your money’s value increases about 1%. This means that you should be storing your money away while in deflation periods for two reasons:
- To have extra money on hand when prices increase, and
- To make an extra couple of percentage points due to the deflation.
- Get That Raise. Though this might be considered a “duh” point, it’s important to understand. Inflation means you’re getting a built in pay cut of at least 3% every year. In the next few years, that’s going to get worse… a lot worse. This means that now, more than ever before, is the time to focus on working harder and doing things that will get you noticed. At this point, getting a raise is often still just a defensive measure.
Remember, the laws of economics don’t change just because we’re having a financially rough time. If anything, this is the time we should focus on the economic and financial principles that get us to prosperity.
This means you don’t have to do anything “special” to combat inflation: just do what you already know you should do. Extraordinary financial times call for extra ordinary financial measures.
How is inflation impacting your long-term savings plans?