Inflation and Why It Matters
Inflation is a term that frequently enters conversations and news headlines because inflation can play a role in your daily budget and financial planning. Understanding inflation is essential for making informed financial decisions and navigating the ever-changing economy.
In recent years, as we emerged from the COVID-19 pandemic lockdowns with larger sums of money and a willingness to spend, inflation became a threat to both household income and the economy for the first time since the 1980s.1 Prices have surged 20.8% since February 20202, meaning we would need about $1,208 to buy the same goods and services that originally cost $1,000.
What is Inflation?
Inflation occurs when the items consumers regularly buy – from services such as haircuts or medical care to goods including appliances and furniture – increase over a sustained period. It doesn’t happen overnight, and it doesn’t happen when the cost of one product increases. Inflation applies to the broader picture, affecting a wide range of goods and services across the economy.
The Causes of Inflation
There are several factors that can contribute to inflation:
- An increase in the demand for goods and services by consumers may cause prices to rise because businesses can’t produce enough to meet that demand.
- Supply chain disruptions, such as natural disasters or geopolitical events.
- Changes in government policies, such as increases in the minimum wage or changes in tax rates.
- Rising costs of raw materials may cause businesses to pass those costs onto consumers in the form of higher prices.
- When people expect prices to go up, they may spend more now, which can also drive inflation higher.
How Inflation is Measured
Inflation is measured in two ways:
1. The Department of Commerce’s Personal Consumption Expenditures (PCE) index.
PCE is crucial for the Federal Reserve, helping policymakers determine what to do next with their key benchmark interest rate.3
2. The Bureau of Labor Statistics’ Consumer Price Index (CPI). CPI matters primarily for consumers.
It provides information on how prices are changing on almost 400 individual items. By comparing the cost of goods over time, economists can determine the rate of inflation. The CPI is calculated monthly and is one of the most widely used measures of inflation.
Why the Federal Reserve Targets 2%
Inflation The Federal Reserve aims to maintain a 2% inflation rate per year. This rate helps ensure businesses can keep hiring and consumers’ paychecks can keep growing. It also keeps prices rising steadily enough to encourage spending and investing but not so quickly that it destabilizes the economy.4 When inflation rises too quickly, it can lead to a loss of confidence in the economy and make financial planning more difficult due to rising costs.
How Inflation Impacts Your Finances
As prices rise, the cost-of-living increases and your buying power decreases. This means you may need to spend more money to buy the same goods and services that you did before. Inflation can affect the value of your savings and investments, making it more difficult to reach your financial goals. Over time, even small increases in prices can add up, making it harder to save for long-term goals like a down payment on a home.
As prices rise, the effects of inflation play a part in our daily lives, influencing everything from the cost of groceries to the value of our savings. Inflation can be a source of stress and confusion, particularly when saving for major financial goals. A well-diversified investment portfolio has the potential to outpace inflation. Contact a Wealth Management by CommunityAmerica Wealth Advisor to help ensure you’re on track to achieve your goals.
