How to Understand and Manage Inflation in Uncertain Financial Times

Inflation is when prices rise, thereby devaluing the currency in question. What’s the mechanism behind that? What do you need to know to be prepared for the accompanying shakes and bumps in your personal investment choices? Read on to find out how to manage inflation in uncertain economic times. 

What Is Inflation? 

Economists typically use price fluctuations across a basket of defined goods and services to measure the inflation rate. It can also be thought of as the rate of the decline in purchasing power over time. The range of items necessary for an individual to live a full life in our modern world is wide-ranging, and it includes food, gasoline and other fuels, the metals used in industry, utilities like water and electricity, and medical care and other vital services.  

When measuring inflation’s rise and fall, economists look at this highly diversified list of items. Expressing price changes in percentages shows the extent to which a single dollar is able to buy less from this basket than it would have in a specified previous period. The Consumer Price Index (CPI) and the Wholesale Price Index are among the standard tools for measuring the rate of inflation.  

What Is Inflation like Right Now? 

Comparing October 2022 to more recent periods, inflation rates did cool off more than most economists expected. But looked at historically, consumer prices are continuing to rise steeply. The October 2022 CPI rose 7.7 percent in a year-over-year-comparison. Many basics, such as food, energy, and housing, remain at the forefront of the upward pressure on prices. Due to the steep rise of inflation, the Internal Revenue Service has issued new tax inflation adjustments over dozens of categories for 2023.  

Depending on your personal financial situation, inflation might be a bad thing (as it is for most of us) or a good thing (if you own property or tangible commodities assets). Companies can benefit financially from an inflation economy if they offer high-demand goods or services for which customers are willing to pay regardless of price.  

Inflation affects all of us, because it drains the future value away from any money we have saved in the present. If you invested in stocks and bonds and earned 4 percent during a time when the inflation rate was 2 percent, you actually only earned 2 percent on your investment. Inflation means that individual purchasing power, and therefore our willingness to participate in the consumer economy, declines. You’re more likely to ask yourself, “Do I really need that new washing machine or those plane tickets?” Additionally, we may be unable to retire when we would normally expect to. 

Tracking Inflation 

The United States Federal Reserve and other central banks in wealthier countries are constantly engaged in monitoring inflation rates, and they make monetary policy adjustments as needed. In the US, the Fed steps in with adjustments when inflation rates rise too rapidly or by too much. Currently, the Fed uses a figure of 2 percent as an acceptable inflation rate when it comes to balancing the need for maximum employment levels with consistency in consumer prices. 

Deflation and "Stagflation" 

The opposite of inflation is deflation, a situation in which prices fall in tandem with an increase in consumer purchasing power. While this may sound good on the surface, it presents difficulties of its own. People also tend to put off purchases when they know that goods and services will be cheaper in the future. So economic activity tends to be depressed during periods of deflation. 

You may also have heard of “stagflation,” a period of slow growth accompanied by inflation and high rates of unemployment. Stagflation, a common phenomenon since the petroleum crisis of the 1970s, continues to affect the developed world. Stagflation is especially hard for policymakers to mitigate, since tactics used to reduce unemployment typically result in rising inflation, and vice versa. In 2022, some economists have speculated that we might experience a temporary period of stagflation in the near future.  

What Causes Inflation? 

Inflation can usually be traced to one of two primary causes. It can happen when production costs—of salaries or source materials—rise. This is referred to as “cost-push” inflation. When the demand for specific goods and services rises, on the other hand, with consumers being willing to buy at higher prices, we have “demand-pull” inflation. Specific fiscal policy decisions also come with increased risk of driving inflation upward.  

What Can You Do about It? 

So how do you make smart financial decisions that will cushion you against inflation? When preparing your portfolio for inflationary periods, lock in your home mortgage at a 30-year, fixed-interest rate, then consider refinancing as rates come down. Real estate investments—including rental real estate—are generally considered excellent hedges against inflation. For 2022 and 2023, however, experts are advising caution, due to a volatile investment real estate market. 

When inflation is high, the conventional wisdom is to move away from bonds and into stocks, particularly into companies that produce consumer staples or commodities. Diversifying your stock portfolio internationally is often also a good idea. It allows you to enter markets in, say, South Korea or Australia, that may not always align with the rise and fall of US markets.  

Consider opening a CD or money market account when inflation forces interest rates up. Just remember that you can lose purchasing power in these instruments if their yield turns out to be lower than the inflation rate. Choose Treasury Inflation-Protected Securities (TIPS) and other securities investments that offer high protection against inflation. Inflation-indexed bonds also fall into this category. 

Your hard-earned savings aren’t Monopoly money. So before making any investment decision, be sure to consult a qualified, experienced professional you trust.