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What is Inflation?

By Andrew J. Christopher on June 8, 2021
Categories: FINANCIAL PLANNING, INVESTING, RETIREMENT

Inflation isn’t just an esoteric topic for economists to debate. In fact, this financial metric is important for everyone to understand. The rise and fall of prices in the U.S. and the world can have a major impact on your purchasing power, both today and in future years. Here’s everything you need to know about inflation, how it can impact your retirement planning, and what you and your financial advisor should discuss about protecting your funds.

What does inflation mean?

Inflation is the change in purchasing power of a specific currency over a period of time. Prices for goods and services go up, requiring more money to buy the same items. These price changes are ultimately a result of annual inflation. In the short-term, you may not notice the impact of inflation on your ability to buy things. But as years pass by, those price increases could catch up with you if your income doesn’t rise along with it. If you are wondering “what is an inflation rate?” see our blog for more information.

How does inflation work?

Think about the cost of going to a movie theater as a kid compared to the price today. In 1985, the average cost of a movie ticket was $3.55.1 In 2018, the same movie ticket cost $9.11. A kid getting paid $10 to mow the lawn in the 1980s could use that money to see both Back to the Future and National Lampoon’s European Vacation, plus buy some snacks. Today, however, $10 would only pay for a single movie ticket — and no popcorn.

Low inflation is considered to be healthy by economists. The Federal Reserve typically sets the annual inflation target rate at 2%.2 That rate indicates that people are spending money at a healthy level and the price level on goods is not rising too quickly. There may be increases in certain industries because of external reasons, but overall, the general price level of most goods should increase little by little.

While annual expected inflation is healthy and part of economic growth, high inflation can be concerning if it becomes hyperinflationary. It is important for economists to predict and attempt to manage future inflation so they can establish an understanding of inflation’s impact on the broader economy.

Primary causes of inflation

Here are some of the most common factors that influence inflation.

Increased demand for goods

The demand-pull inflation effect is a type of consumer driven inflation resulting from consumer demand. When the economy is healthy, people spend their money rather than save it. This increases the demand for goods and commodities, which causes sellers to increase prices. This type of inflation often goes hand-in-hand with higher wages and low unemployment rates as employers are incentivized to pay better to retain employees.

Increased production costs

Higher production expenses result in cost-push inflation. Suppliers have to pay more for raw materials, which drives up prices for consumers. People aren’t necessarily earning more, so it can cause an imbalance in supply and demand. If prices rise too much and too quickly, it can cause issues within the economy.

In recent years, for example, low interest rates have increased the number of potential homebuyers. But housing inventory is low, particularly because of the economic uncertainty surrounding the COVID-19 pandemic. This has caused a surge in demand for new construction homes, ultimately leading to a global lumber shortage. As a result, lumber prices were up 112% year-over-year as of February 2021.3

Other factors

There are also many other factors that can impact inflation rates beyond consumer supply and demand. Anytime the federal government increases the money supply, for instance, inflation may jump. Large amounts of national debt can also affect taxes, wages, and spending, which influences inflation. Finally, exchange rates can impact the cost of imported goods; if the value of the dollar drops, then those goods will cost more.

Inflation vs. deflation explained

Deflation occurs when the cost of goods decreases. There are both benefits and drawbacks to deflation. For starters, things cost less. But on the flip side, any existing debt stays the same during deflation. Consumers must continue to pay their bills in a currency that has a lower value. And any hard assets securing the loan (like a car or home) will likely be worth less, too.

How to measure inflation

Inflation is measured by the U.S. Bureau of Labor Statistics’ (BLS) Consumer Price Index (CPI). Data is collected every month across urban consumers in the country to determine current prices for a range of goods and services. Here are some of the types of businesses that are regularly included in the CPI:

  • Retail stores
  • Service establishments
  • Rental units
  • Doctors’ offices

The BLS records the prices of over 80,000 goods and services to determine the rate of inflation throughout the U.S. All of the data evaluated through the CPI gives an idea of the price trajectory of daily living expenses.

There are some other inflation indices that measure other types of prices. The Producer Price Index from the BLS tracks selling prices of domestic producers while the International Price Program looks at changes in the cost of imports and exports. The Employment Cost Index analyzes labor market costs. All of this data can be used to determine how dramatically prices and wages are rising or declining.

How inflation impacts retirement planning

It’s important to understand inflation because it means that the dollars you save today won’t take you as far as when you actually use them in retirement. There are two distinct ways inflation can throw off your retirement planning.

Diminished buying power

When you are discussing how to create a financial plan, you need to account for inflation in your retirement strategy because things will cost more when you retire than they did in the preceding decades. Not only do prices increase, but your need for more expensive goods and services, especially healthcare, will also rise at some point. These are all factors to consider when creating your holistic financial planning strategy. If you are wondering how to start a retirement plan, see our retirement planning blogs.

Lifestyle inflation

Economic inflation isn’t the only concern for retirees. Lifestyle inflation is when your expenditures in retirement exceeds what your portfolio can support. This could be for a number of reasons, like traveling more or purchasing a vacation home.

3 ways to protect your retirement income against inflation

Even with economic and lifestyle inflation, there are many things you can do to prepare in advance. No matter what stage you’re in, start thinking about how to proactively address inflation before it impacts your future purchasing power. Your financial advisor should help you implement these ideas in a way that’s specific to your financial situation and your goals.

Invest with inflation in mind

Together with your financial advisor, be sure to include inflation as part of your long-term investment strategy. That means setting your financial goals to account for your increased cost of living in the years ahead. A major aspect of this is choosing the best risk management plan so that you’re growing your portfolio more than the inflation rate, while still diversifying your asset allocation.

A smart tax strategy also ensures you’re minimizing your tax bills both now and at the time of distribution so you don’t lose unnecessary funds that you’ll need later on. Understanding how to invest in each stage of life can be complicated. Choosing a financial advisor like Dowling & Yahnke Wealth Advisors helps you establish a relationship so you can pivot and grow your investments as needed to be truly prepared for retirement.

Make realistic lifestyle choices

The lifestyle choices you make today influence the range of choices you’ll have later in life. Your D&Y financial advisor can help you balance the present and future to make sure you’re not just prepared, but also able to enjoy yourself and achieve your life goals. For instance, they can help you weigh whether to work longer to accumulate more or save more aggressively so you can retire early.

Also remember to plan for increased healthcare costs. Not only will the price of healthcare continue to rise because of inflation, you’ll also use more services as you get older. Your advisor can help plan for these future expenses so that you’re not caught off guard by higher prices early in your retirement.

Create a smart withdrawal strategy

As you enter your retirement years, your distribution strategy can stretch your wealth to last longer in the face of inflation. Social Security and Medicare planning can be complicated, and the timing can impact the value of benefits you receive for the rest of your life.

IRAs come with a Required Minimum Distribution once you reach a certain age, which can impact your tax bill. Finally, if you have a pension, you also need to consider your distribution election options. Your financial advisor considers your full portfolio of assets to minimize your taxes and protect your wealth even through your retirement.

The Bottom Line

Inflation may not be something you can reach out and touch, but it’s something that has a very real impact on your life. Prepare for rising living costs today by creating a long-term relationship with an experienced financial advisor. They can help ensure your retirement plan is robust enough to meet your future financial needs while still helping you reach your lifestyle goals as well. If you are wondering, “how do I find a financial advisor for retirement,” reach out and contact our team of trusted financial advisors today.

 


1. https://www.usatoday.com/story/money/2019/08/29/cost-of-a-movie-ticket-the-year-you-were-born/39998123/
2. Powell, Tyler, and David Wessel. “What Do Changes in the Fed’s Longer-Run Goals and Monetary Strategy Statement Mean?” Brookings, Brookings, 2 Sept. 2020, https://www.brookings.edu/blog/up-front/2020/09/02/what-do-changes-in-the-feds-longer-run-goals-and-monetary-strategy-statement-mean/#:~:text=With%20this%20new%20approach%2C%20the,percent%20on%20average%20over%20time.
3. Olick, Diana. “Lumber Prices Skyrocket, Pushing up Housing Costs.” CNBC, CNBC, 10 Feb. 2021, https://www.cnbc.com/2021/02/10/lumber-prices-skyrocket-pushing-up-housing-costs.html.

 

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