Inflation is complex and daunting when you’re trying to manage your own finances, but it's easier to understand once you grasp the fundamentals of how it works.
In August 2020, Federal Reserve Chairman Jerome Powell announced plans to allow inflation to run slightly higher than the typical 2% goal that was long held, stating: "inflation that is persistently too low can pose serious risks to the economy."
In the months since, you’ve likely noticed the costs of many goods and services going up. Rising prices for gasoline, lumber, meat, and other items are straining household budgets for the average American. Any way you measure it, 2022 has already hit inflation levels not seen since the 1980s. The current wave of inflation might have peaked, according to some — but it certainly isn’t over.
The subject of inflation can seem complex and daunting when you’re simply trying to manage your own financial plan, but it's much easier to understand once you have a grasp of the fundamentals of how it works. Read on to learn more about the mechanisms behind inflation, and the steps you can take today to protect yourself from the worst impacts of rising prices.
Indicators of economic inflation
In short, economic inflation measures how much the prices of goods or services increase over a given timeframe. Economists often look to the Consumer Price Index, or CPI, to track the rate of price increase for common household items year over year (YOY). This index includes the prices of necessities like rent, groceries, and energy.
Over the past 12 months, the CPI index has risen by 7.9% on average across all categories tracked, with the most substantial increase seen in energy prices.
To get a more precise picture of how the financial stress of rising costs is impacting consumers, it's essential to also consider changes in core inflation by evaluating the Personal Consumption Expenditures index, or PCE index. While the CPI index focuses on measuring the expenses of primarily urban households, the PCE index tracks the percentage change in prices paid for goods and services across all households in the country.
Currently, core PCE inflation stands at 7.1% since January 2021, representing the largest increase in personal consumption expenditures since 1983. Taken together, rising PCE and CPI inflation signal an inflationary environment that could easily persist for the rest of 2022.
That's what indicates the presence of inflation from an economist's point of view. The higher prices you’re paying for protein at the grocery store and gas at the pump are what have likely indicated it to you. So why is it happening now?
Causes and effects of inflation in 2022
Much of the inflation you're experiencing today began with the COVID-19 pandemic. In an effort to slow the spread of the virus, many businesses across the U.S. scaled back their operations or closed altogether. Around the same time, a series of aid packages coupled with increased unemployment benefits made it possible for workers across several major industries to safely remain at home until the worst of the pandemic passed.
As the economy started to open up again, businesses lost workers and struggled to meet increasing demand.. This is one factor explaining the increase in cost of goods and services, known as demand-pull inflation, but it's not the only cause for increasing prices seen in today's economic environment.
Supply chain disruptions brought on by labor shortages and lockdowns are another major factor. When you can't find the specific fabric softener you used to prefer, you can see that products are still not back to their pre-pandemic production levels. With less goods and services available to meet rising demand, prices for many consumer products go up, resulting in what's known as cost-push inflation.
Together, demand-pull inflation and cost-push inflation contribute to higher living expenses. Ultimately, the growth and sudden improvement of the economy got the inflation ball rolling.
It's also possible that higher inflation could drive up the labor costs of businesses in the future, requiring them to charge more for their products and services. Given time, this may create a self-perpetuating cycle of built-in inflation where wages increase to offset inflation, causing prices to go up further as a result. Added together, the economy — and the consumers — face a one-two-three punch of factors that bruise your financial wellness.
What can be done about inflation?
When assessing the underlying causes of inflation in the U.S., some critics point to the monetary policy decisions of the Federal Reserve Bank, which have drastically increased America's money supply over the past two years through economic stimulus packages and quantitative easing (printing new money). This is called the quantity theory of money and could play a role in the rising inflation rates people see in 2022.
The exact causes of America's inflation rate are debatable and include other complex factors such as the current conflict in Ukraine, national policies from country to country, and the ongoing effort to reach post-pandemic financial stability. The widespread financial stress is readily apparent even if the solutions are not immediately obvious.
On a national scale, the task of managing America's inflation largely falls to the Federal Reserve Bank, which controls the money supply and provides guidance for financial institutions that set the prevailing interest rates for loans, mortgages, and other products. To help curb inflation, the Federal Reserve Bank will periodically increase interest rates to place downward pressure on economic activity.
The expectation is that by making borrowing more expensive, economic growth will slow down, and this decreased demand will lower the prices of various goods or services. For your everyday money management, that slowdown may be a positive thing. The Federal Reserve's monetary policy with regard to inflation in 2022 is expected to include several marginal rate hikes that may help to relieve some inflationary pressures in the market.
It takes time for an increase in the cost to borrow money (in other words, the interest rate) to register a change in inflation levels. In the meantime, an inflationary environment continues to contribute directly to decreased purchasing power for users of the currency involved: everyone who buys gas, groceries, and goods. If the price for goods or services is higher in terms of dollars, anyone using dollars to pay for those goods or services will feel the effects.
While it may sound contradictory, this can lead to consumers buying more products and services, since inflation expectations point to higher prices in the future. Consumers are more likely to invest in durable goods, assets, or stocks during inflationary times to hedge against additional declines in the purchasing power of cash.
How inflation impacts your finances
How does this all impact your bottom line?
High inflation can negatively affect your personal finances in many ways. Again, one obvious effect of an increasing inflation rate is a relative decrease in the immediate purchasing power of your money. It costs more money to get the goods and services you want and need.
To reduce your variable expenses, it may be necessary to alter your spending budget to compensate for rising prices. Consider exploring alternatives to goods and services you typically buy or cut discretionary spending as needed to meet other rising living costs. Move from a “spender” to a “saver” where possible.
If you’re diligent about how much money you spend in each of the categories of your budget (such as fuel, food, housing, utilities, entertainment, savings, etc.), you'll likely have noticed increased price tags in your food or fuel expense. If you shift dollars away from your savings to cover the difference, this may cause a longer-term impact on your financial goal. So what other options are available?
Long-term changes to your financial goals
It’s smart to examine your financial health at every age, but especially during times of rising inflation. Since purchasing power diminishes as inflation increases, simply storing cash away in a safe is likely not the best approach. Instead, consider moving your savings to a high-interest-bearing savings account that can keep pace with rising inflation.
You may also want to begin looking at investment opportunities as a chance to protect your savings. Putting money into an ETF (exchange-traded fund), mutual fund, or short-term bond is often a good idea, especially if you're sitting on a considerable amount of money that isn't accruing any interest. Other helpful saving tips include paying off any interest-bearing debt, reducing energy consumption in the home, or finding a financial institution that can refund ATM fees.
If you're currently enrolled in a health care plan, spend some time shopping around for more affordable premiums that offer a similar level of coverage. Another way you can save more during inflation is to avoid buying big-ticket items such as a new car.
According to the Bureau of Labor Statistics, the average American spent $9,826 on transportation costs in 2020, an increase of 10% from the previous year. If you plan on buying a car, truck, or SUV when inflation is high, think about finding a used vehicle that can suit your needs instead of buying something brand new.
These options may help your financial situation, but you might also be looking for immediate solutions. There are ways to impact your living expenses right now.
10 tips for dealing with inflation today
Practicing sound financial self-care is another critical step to protecting your money during times of high inflation. This includes keeping track of your income versus your variable and fixed expenses, setting realistic financial goals, and educating yourself on the fundamental principles of money management.
Being prepared is the single best strategy to protect yourself from declining purchasing power and higher prices. Knowing what to expect and taking action ahead of time can save you from financial stress later. If you're worried about how inflation will affect your finances today, tomorrow, and next week, here are several proactive steps you can take to preserve your wealth right now.
1. Assess your emergency fund. Periods of inflation may be the time you find it necessary to tap into your emergency fund. Don't let this add to your money worries — that's why you have an emergency fund. If you need to adjust your cash flow, contributing less to your emergency fund may be an option, even if you are not quite ready to pull funds out of your nest egg.
2. Devise an inflation savings plan. Maybe your emergency fund isn't ready for the impact of inflation. That's okay. It's been a roller coaster the last few years. Take some time to create a customized savings plan that works for your budget.
3. Trim daily costs. Aside from simply putting money away each month to pay for unforeseen expenses, look for ways to cut costs on the goods and services you already buy regularly. Even if just a little.
For example, consider buying select grocery items in bulk to save a little cash, or use coupons to minimize your total at checkout. You may also want to revisit your car and health insurance coverage to see if other plans or providers could reduce monthly expenses like prescription fees. Managing your known expenses positions you in a better spot when an unexpected expense pops up.
4. Simple lifestyle changes. Consider basic changes that improve your spending in ways you might not have considered in the past. Everything from carpooling to work to exchanging child care support with a neighbor might trim a little from the budget and make an impact.
5. Explore other hedges against inflation. Along with treasury inflation-protected securities, REITS, or gold, look into alternative inflation hedges that can preserve the purchasing power of your money. Additional investments that can work as an inflation hedge may include other precious metals like platinum and palladium, fine jewelry, or rare books.
Another option to consider as a hedge against inflation is cryptocurrencies like Bitcoin or Ethereum. While cryptocurrencies are a fairly new phenomenon with little data supporting their performance during high inflation, their independence from movements in global financial markets might make them a good addition to any diversified portfolio.
6. Ask for help. If you're on a fixed income like social security and relying on your retirement income and benefits, it might be helpful to speak to a financial adviser. You may prefer to move your current investments into more traditional investment vehicles like bonds or CDs, where you're guaranteed at least some return on your principal investment as opposed to risky or uncertain investments.
7. Avoid relying on credit cards. When the inflation rate starts rising, credit card companies may begin to charge higher interest rates than they did before. This can be a problem if you have an outstanding credit card debt, as the balance owed can start to climb quickly, making it more difficult to pay down.
During periods of high inflation, try to use cash whenever possible and reserve your credit line for emergency expenses only. Leaving your credit card at home next time you go shopping will improve your financial situation if inflation continues to climb.
8. Monitor your credit report. Paying off credit card debt will also help improve your credit score, potentially giving you access to a larger credit line that could be useful when inflation lowers. For now, keep tabs on your credit report. Even if it takes a couple small dings as you manage your variable expenses, it's wise to know exactly where you stand financially.
9. Skip the impulse purchases. It's also advisable to avoid impulse buying during rising inflation so you can have more cash to pay for the increased cost of recurring bills and necessities.
10. Mind your financial self-care. By following some of the tips above, you can lessen your exposure to inflation risk and make better financial decisions during these uncertain times. It's more work to manage your financial situation during inflation, but any financial problems that might be creating more stress are not a difficulty you are facing alone.
Inflation impacts everyone. Money worries can be reduced by reaching out to your local banker who recognizes that how you manage your financial situation may have similar causes, but can offer you more personalized support.
Don't let the financial stress of the current economic climate get between you and your personal finance goals. Keep these tips in mind to stay ahead of inflation and preserve your wealth from rising prices.