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Assuming you haven’t been living under a rock over the past few months, you’ve probably heard the term “inflation” tossed around. And when I look around at the prices of things now, it’s glaringly obvious that inflation has been at work all along.
Inflation simply means that the monetary supply of a nation is increasing. With more money in circulation, demand for everyday goods and services rises, meaning, prices go up, and the buying power of all money goes down.
While inflation is constantly at work behind the scenes, it’s sometimes hard to explain why we feel the way we do about it or if inflation is really as bad as people make it out to seem in the first place.
So if you’re wondering what in the world inflation is all about, we’re gonna break down everything you need to know.
In this article, we’ll cover:
What Is Inflation?
Think about when you inflate a balloon. It rises up to the ceiling, right? Similarly, when an economy experiences a period of inflation, prices of goods and services rise.
When prices rise (for any number of reasons we’ll go into below), the value of our money, or our consumer purchasing power, goes down.
That means it takes more money to purchase everyday goods like a gallon of gas or a carton of eggs.
When my dad was a boy, he filled up his first car for around $.60 a gallon compared to the almost $3 I’m used to paying today.
That’s a 5 times increase in the last 40 years.
The thing about inflation is that it tends to happen across economies, and it can’t necessarily be stopped.
For example, in the US, the Federal Reserve is responsible for trying to control inflation through measures like increasing interest rates for borrowers in an attempt to curb spending.
And while these measures can help sometimes, they can’t ever truly stop inflation in its tracks.
Most economists agree that there are three main types of inflation.
- Built-in inflation: This run-of-the-mill inflation essentially goes unnoticed. As prices go up, wages generally go up to match, and we remain in a relative state of economic balance over time. You may be familiar with an annual “cost of living increase” at work. Those exist to help combat the inflation that’s regularly happening over time.
- Demand-pull inflation: Demand-pull inflation happens when there’s an influx of money and credit into an economy. When people have more money to spend, there’s a greater demand for products and services. And that demand can outpace the economy’s ability to produce said goods, which means prices go up because there’s less supply available. Real estate is an excellent example of demand-pull inflation. As we’ve seen over the last year, there’s a greater demand for homes, of which supply is dwindling. And demand-pull inflation has been at work across the country, reflected in the rising cost of homes.
- Cost-push inflation: When it costs more to produce something, the producers need to pass along some of the cost to consumers. For example, if the price of coffee beans rises, Starbucks needs to charge you more for your morning coffee.
Behind the scenes for each type of inflation, there can be several sudden triggers for inflationary cost increases. These might include:
- Natural disasters: Disasters might include hurricanes, winter storms, or a global pandemic that disrupts supply chains and makes raw materials less available for commonly used products.
- Companies raising prices: When companies need to pay employees more money to stay competitive, they may increase their prices to pass along the expense to consumers. Companies may also raise prices when the cost of raw materials used to create their products increase.
- Sudden economic expansion: When there’s a sudden influx of money into the economy, consumers will have an increased demand for products, causing an upward shift in prices. We’ve recently seen a massive influx of government stimulus money that means consumers may have more money in their pocket to put towards goods.
When one or more of these scenarios happens simultaneously, it’s a recipe for disaster. And as with any disaster, there are bound to be winners and losers.
Who Benefits From Inflation?
It seems that every economic situation produces winners and losers.
As we saw with the pandemic, some people were walloped in the wallet, but others came out with boatloads of money from making smart investments.
When inflation rises, one group of winners are people who have borrowed money at a low fixed rate.
For example, several years ago, I bought a car with a 5-year loan at a fixed interest rate of 2.74%.
So as inflation goes up, I'll actually pay less to the dealer than what it would cost me if I were to buy that car now.
Other winners are companies that can charge more for their products and investors with assets positively impacted by inflation.
For example, assets like real estate or a particular sector of stocks like tech could get a considerable boost due to inflation.
The losers of inflation tend to be those who hold a lot of money in cash, those with fixed wages like retirees, and borrowers with variable-rate debt.
As a huge proponent of having a fully-funded emergency fund, I struggle with how to handle cash during inflation since it’s sort of a catch-22.
I hold around $20,000 in an emergency fund. And that money isn’t making diddly squat.
Now I could take that money and put it in the stock market in assets that I think will rise with inflation. But that also means I’m putting my security blanket in jeopardy, which I’m not comfortable doing.
So I’ll take being a loser and potentially missing a sweet earning opportunity to know that I have that cash buffer in my corner, especially since we don’t know exactly how long any period of inflation might last.
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Why Is Inflation Rising Right Now?
According to the Bureau of Labor Statistics consumer price index (CPI), prices rose at a staggering 9.1% year-over-year since July 2021.
Compare that with the approximate 2% inflation per year, which is considered normal, and you’ll see how truly alarming that number is.
And if you’ve tried to buy a used car, any sort of lumber, or a home in the past year, you’ve seen the impacts of this dramatic price increase firsthand.
But why?
For one, there have been extensive supply chain issues as a result of the pandemic.
And an increase in the cost of raw materials that we get through these supply chains is a textbook example of cost-push inflation.
Let’s sneak a peek at lumber, for example.
During the pandemic, the inputs required to source, mill, and transport the lumber required for things like building new homes were heavily impacted by shutdowns and increased COVID safety requirements.
Add that to the fact that hundreds of millions of people are now sitting at home thinking about all those fabulous home renovation projects they should be doing (guilty as charged).
So when people start running out to grab lumber for those projects or simply say, “you know what, it’s definitely time to buy that bigger house we’ve been putting off,” you’ve got a perfect storm of demand-pull inflation.
So if you’re a math person:
Less lumber available + more people wanting lumber = higher price for lumber
But what we’ve seen hasn’t just been limited to lumber. It’s happened with chips for automobiles, toilet paper, air conditioners, and practically every consumer good you can think of.
And while “normal life” is slowly returning, it could be some time before we see the supply chains catch up to demand and actually experience an evening out of prices again.
Another reason we’re seeing this wave of inflation could be related to the massive influx of money into the economy over the past year.
The Federal Reserve “printed” money to the tune of around $4 trillion.
As a result, you can see in the graph below a significant spike in the total assets of the Federal Reserve starting in 2020, the likes of which haven’t been seen over the past 15 years.
Source: https://www.officialdata.org/us/stocks/s-p-500/1957
And while those stimulus checks have been such a blessing to families in need, they’re not without consequences.
As more money is pumped into the economy, our buying power goes down. And at the same time, people have money to spend, which means higher demand and higher prices.
With any incidence of inflation, there’s normally not a single input you can point to and say, “that’s what did it!”.
Instead, it’s typically a combination of factors, like those we’ve seen in full force with the COVID pandemic.
But rest assured that as we work through this latest period of inflation, whether it lasts months or years, there are ways to protect ourselves.
4 Ways To Combat Inflation
So, now you know what inflation is, but is there any way to actually beat it?
Below are the 4 best strategies to beat inflation in 2022.
1. Increase Your Earnings
It would be great if employers could significantly boost salaries as inflation is anticipated to rise above the norm.
But that’s just not the reality. Instead, you may look to part-time work or side hustles during a time of economic inflation to create extra money.
If inflation is currently sitting around 5%, you’d need to increase your income by 5% to break even.
And any money you make on top of that is a bonus which means you’ll beat inflation at its own game. Failure to earn more money, though, means you’re continuing to lose money as your purchasing power falls.
If you’re lucky enough to be self-employed, like me, you could raise your rates to make up for the higher cost of goods.
However you choose to do it, earning extra income can help cover the higher prices of groceries and everyday needs caused by inflation.
2. Press Pause On Savings
When you put money into a traditional savings account, or even a high-yield online savings account, the most you can earn at current rates is around 1%.
That means with inflation sitting closer to 5%, you’re actually losing 4% on your money while it sits in your account.
As I mentioned previously, keeping an emergency fund is essential, especially in trying economic times.
But it may be wise to steer clear of dumping any future savings into a traditional savings account during this inflationary period.
Instead of keeping your vacation savings tucked away at your local credit union, it might better serve you to put that money in a taxable brokerage account where you have the potential to beat inflation.
3. Invest (and not in bonds)
Since bonds are fixed-income assets, meaning they pay the same guaranteed amount for months or years, they may not keep up with inflation.
And that means in an inflationary period, many people rush to sell off bonds, further encouraging a greater loss for remaining bondholders.
The best way to hedge against inflation is investing in the stock market. That’s because generally, the stock market tends to outpace inflation, meaning that inflation rises, but the markets will typically rise higher.
Since the S&P was created in 1957, it has averaged returns of 10.34% per year. Adjusted for inflation, that’s a return of 6.5%. Not too shabby.
If you’re into individual stock picking, choosing companies that create necessities can be a smart move.
As prices rise, people may cast aside non-essential purchases, but they’ll keep buying toilet paper and other household staples.
4. Trade Variable-rate Debt For Fixed Rates
When inflation occurs, you’ll have less purchasing power relative to the cost of goods and services.
And that means you’ll want to keep expenses in check. One way to do that is by creating as many fixed-rate payments as possible.
Variable rates can fluctuate based on market changes. So if you have a mortgage or auto loan, try to lock in a lower fixed rate instead.
You may also want to pay off any outstanding credit card or loan debt that’s set at a variable rate.
Unfortunately, the interest rates can spike seemingly without notice and will end up costing you a lot more during a time when you’re already hurting.
Final Thoughts – Inflation And Why Its Rising
Long-term excessive inflation will put a financial strain on many people. And our reality today is that we’re going through an inflationary period, and we don’t know how long it might last.
But always remember that there are ways to hedge against inflation, including:
- Increasing your earnings
- Only keep the amount of cash necessary for your emergency fund
- Investing in the stock market
- Locking in fixed interest rates where possible
- Holding off on larger purchases if possible until prices even out
Times of inflation typically aren’t ideal for making sweeping life changes and huge purchases.
So be smart, focus on spending wisely and earning more, and you’ll be able to safely ride this inflated balloon back down to a reasonable place.
