Inflation And Its Effect On Your Savings
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A savings plan is a vital part of any successful financial planning. Whether it’s tucking money away to eventually put a down payment on a home or investing in the stock market to realize a comfortable retirement in the future, a savings plan is essential.
But saving money is not always a straightforward process. The rising cost of things like food, childcare, education, utilities, and a host of other items sometimes seems to outpace the growth of our bank account balances. One of the main culprits behind these soaring costs is inflation.
What Is Inflation?
Inflation is defined as the decline in the value of money over time. This decline results in a general and sustained rise in prices. For a trend in rising prices to be characterized as inflationary, it must occur on a broad scale, affecting most goods and services in the economy. One-time price spikes that occur periodically or that impact only certain products are not examples of actual inflation.
Inflation is ultimately about the loss of a currency’s purchasing power due to an increased money supply. If there’s too much money circulating in the economy relative to the products available, inflation occurs. This is why economists sometimes describe inflation as “too much money chasing too few goods.”
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Economists measure the rate of inflation using an indicator called the Consumer Price Index (CPI). The CPI tracks price changes for a predetermined basket of goods, consisting of items generally purchased by consumers, such as food, shelter, and clothing.
Though not perfect, the CPI conveys crucial information about the level of inflationary pressure in the economy. Consumers, businesses, and governments use this information to guide their spending, pricing, and investing decisions.
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What Causes Inflation To Rise?
There are many reasons for rising inflation rates. Some of the most common ones are:
In an expanding economy, the production of goods and services increases, resulting in a low unemployment rate and upward pressure on wages. As a result, consumers end up with more income that they can spend on necessities and luxury items. The increased demand for products serves to increase prices, which leads to more business investment, more job growth, and more money circulating in the economy. This cycle continues until economic output peaks and demand dries up, at which point a recession may set in.
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Supply chain shocks can accelerate inflation by significantly changing the cost of production. The most notable example is oil, a resource that directly or indirectly affects almost every industry. Should the price of oil increase rapidly, production costs for many types of goods will rise. Producers, in turn, will pass on these costs to consumers by charging more for their products.
This scenario is an example of cost-push inflation, so-called because an input cost is literally “pushing” prices higher.
Increase In The National Debt
When the national debt surges, this results in massive inflationary pressure, which eventually spills over into prices.
One way the government can fund its expenditures is by bumping up the corporate tax rate. Usually, the result is that corporations pass on the tax hike to consumers in the form of higher prices, a clear example of cost-push inflation.
Another method of government financing involves simply printing more money. By increasing the money supply, households gain more spending power, which causes a rise in demand for goods and services. The soaring demand induces firms to raise prices, resulting in what’s referred to as demand-pull inflation.
How Does Inflation Affect Purchasing Power?
To better understand how inflation impacts your purchasing power, think of a 4-litre container of milk. Assume it currently costs $4.45. Suppose the annual inflation rate is 3%. In that case, your purchasing power will decline by 3% every year, which means the milk container will become increasingly expensive.
Below is a table that shows how the price of a milk container will steadily rise in the future if the 3% inflation rate persists.
|Time period||Cost of 4 litre milk container|
How To Protect Yourself From Inflation?
You can counteract the damaging effects of inflation by employing the strategies below.
Diversify Your Investment Portfolio
Diversification helps to reduce risks that could adversely affect your investment portfolio, and inflation is undoubtedly one risk that requires special attention. Proper diversification will enable your investment portfolio to withstand inflation and maintain its value over time.
Not all types of financial assets behave the same during periods of rising inflation. Some lose value, while others retain or even increase in value.
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If you anticipate rising inflation, look to invest in areas that have historically fared well against it, such as precious metals, energy, and agricultural commodities.
Reduce your exposure to fixed-income assets such as bonds. Bonds and other types of fixed-interest rate investments usually perform poorly during periods of high inflation. This is because inflation usually causes interest rates to rise, and rising interest rates cause bond values to fall. Long-term bonds experience sharper price declines, so if you plan to hold some bonds, invest only in the short-term variety.
Don’t have a lot to invest? Consider investing in ETFs.
Consider diversifying internationally by investing in countries whose economies don’t correlate with the Canadian financial markets. For example, if countries in the European Union are experiencing little or no inflation, allocating some of your money to that region can offer some protection from domestic inflation.
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Invest In Stocks
Stocks have historically been a great hedge against inflation, beating most other types of asset classes. Massive, sustained inflationary pressure can impact stocks negatively in the long run. However, firms’ ability to increase prices of their goods and services does a lot to offset inflation’s harmful effects.
It’s critical to remember, however, that not all stocks do well during inflationary periods. When selecting stocks, stick to sectors that have traditionally done well under such conditions, such as oil, healthcare, gold, and utilities.
Don’t know how to invest? Check out our beginners guide on investing.
Invest In Real Estate
Real estate is also an exceptional asset class that can help protect your savings from inflation. Real estate value generally keeps good pace with inflation, though it doesn’t typically generate the higher returns stocks do.
You can invest in real estate directly by purchasing a property or indirectly by purchasing real estate investment trusts (REIT). REITs offer a convenient and practical way to invest in real estate without buying the underlying properties themselves. The rates of return on REITs also tend to be higher than bonds, offering your investment portfolio more stability during inflationary times.
Invest In Real Return Bonds
Real return bonds (RRB) are bonds issued by the Canadian federal government. What makes these bonds unique is that the principal and interest payments increase as inflation rises.
An RRB’s interest rate is reset semi-annually, based on CPI figures. The process continues until the bond matures, at which point you’ll receive the inflation-adjusted principal. These features make real return bonds an excellent choice to include in your investment portfolio, as the periodic adjustments effectively shield them from inflation.
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Is inflation good or bad for savings?
Inflation, like taxes, is here to stay. Though there are occasionally periods where inflation is absent from the economy, the trend throughout history has been marked by rising prices – and this is likely to continue.
Though you can’t stop inflation yourself, you can shield your savings from it by making prudent investment decisions. Be sure to explore the different ways you can inflation-proof your portfolio and execute a plan that works best for you.
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