Inflation has been a driving factor for both markets and the economy in 2022. But concerns about inflation are nothing new — it’s one of the most talked about concepts, since it impacts our savings, spending, investments, and more.
With that in mind, we want to take some time to go over what inflation is, how it’s measured, and the way all of this has the potential to affect your financial well-being.
What is inflation?
Inflation is the rate at which prices change over time. For example, if something costs $1 today, and $2 a year from today, the price jumped 100%. So, its rate of inflation is 100%.
In the real world, it’s not always so straight forward. For starters, we need to know how prices are changing across the board, not just on a single item. The government accounts for this by tracking the price of a “basket of consumer goods and services” — things like food, personal care products, medical expenses, and so on. It then monitors how those prices change over time. This is what’s known as the consumer price index (CPI).
CPI is the main metric for tracking inflation in the U.S., and it’s the number we most-commonly share in our market updates when discussing price changes.
While the government bases the basket on actual goods consumers report buying, there’s generally a lag between when they survey consumers, and when the indicator is updated. It’s also important to note that CPI tracks prices paid by urban consumers, specifically, and ignores some major expenses, like housing or health care premiums.
It’s also possible that CPI doesn’t reflect the goods or services you consume, or that prices in your area are moving differently than the country as a whole. Ultimately, this means CPI isn’t an entirely universal measurement.
The government does track a second inflation indicator that’s discussed a bit less frequently: producer prices. The producer price index tracks the prices paid by business owners for raw materials, and it can help provide a more nuanced understanding about what’s causing inflation.
It’s worth noting that commodity prices often increase during periods of inflation. This can drive costs up for some businesses, but it can also benefit companies and employees that work with raw materials, like oil companies or farmers.
Why does inflation matter?
Simply put, inflation tracks how much a dollar can buy. If the price of an item increases from $1 to $2, and you only have $1, you can no longer afford that item. Put another way, your money doesn’t go as far, and your purchasing power shrinks.
If you’re living on a fixed income, it’s especially important to understand how far that income will go. That’s one reason inflation risk is something we track closely when clients retire. It’s also a driving factor behind our approach to income planning in retirement.
We typically estimate income needs in 12-month increments so we can adjust as needed over time. We also keep a portion of retiree portfolios devoted to growth, with the goal of offsetting any potential inflation.
It’s also important to note: Inflation doesn’t typically jump from 2% to 9% overnight. There are usually warning signs that prices might be increasing, which we monitor closely. (If you’re ever curious about what economic factors we’re watching, check out our monthly market updates.)
We aren’t the only ones who monitor inflation closely. Social Security payments are adjusted for inflation, too. The cost-of-living adjustment (COLA) is tied to CPI. Keeping inflation in check is also one of the primary jobs of the Federal Reserve, and they often adjust monetary policy in an attempt to keep prices stable.
Context is key
On average, inflation measures around 3% per year, but it’s not uncommon for that number to jump. CPI topped 10% in 1974, 1979, 1980, and 1981, for example. Meanwhile, as recently as 2019 and 2020, CPI was below 2%.
Inflation isn’t inherently bad — a certain amount of inflation is normal in an expanding economy. Just consider how prices have evolved since 1950: Things are significantly more expensive now, in comparison, but the economy grew significantly during the same period.
Stagflation, however, refers to inflation that occurs when the economy is stagnant, as indicated by low consumer demand or high unemployment. That is a particularly troubling phenomenon, since it often indicates that consumers won’t be able to afford higher prices.
This link between inflation and affordability is also apparent across income levels. Inflation tends to have a more profound impact on people earning less money. That means it may be more important to focus on charitable giving during periods of inflation, to ensure those we want to help can maintain access to food, clothing, shelter, and other basics. As we review our clients’ charitable giving plans, we may take some time to ensure your donations have the maximum impact under current circumstances.
If you have questions about our outlook for inflation, or how we factor inflation into investing and planning decisions, we can discuss at our next client meeting.
Sources: Bureau of Labor Statistics, Minneapolis Federal Reserve, CME Group, Investopedia, Merriam-Webster