What is Inflation

Hi everyone, and welcome back to Melissa Making Cents!

As a CERTIFIED FINANCIAL PLANNER™ and a financial coach, I talk to clients about the economy and current economic trends and conditions all the time. And to be completely honest, the economy is something we should all be following and up to date on. It affects/will affect all of us and our daily lives in one way or another. So whether you're a titan of industry or just filling up your tank at the local gas station, the economy and its health will have an effect on how much you're paying.

Something that's extremely closely tied with how the economy is doing and will also affect how much you pay for goods and services is inflation! It's become a scary word, and there's been much media buzz around inflation lately. The pandemic, shutdowns, elections, and all of their ramifications have everyone worried about inflation and what's going to happen. 

Before we add inflation to the blacklist, I do think it is important to share that inflation tends to get a bad reputation.  As my grandmother would say... "It's not all that bad, it's just misunderstood". Simply put... our economy needs a bit of inflation for growth and overall economic health.  Inflation contributes to the increase in the stock markets, cost of living adjustments, and wage increases.  Inflation only becomes a problem to your financial plan if it gets crazy on us!

I think it's essential that we understand what's happening with inflation, what it is, and how it's going to affect all of us. Because of this, I've decided to devote today's blog post to brush up on it! One reason many people don't know much about what inflation actually it is because they're overwhelmed. Don't worry, you won't need to have a bachelor's in economics to easily follow along with this one!

A Definition of Inflation 

According to Webster's Dictionary, a formal definition of inflation is "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services." Unfortunately, this definition is a great way to illustrate why people don't know what inflation is. 

Of course, this is a great definition, and it accurately captures economic inflation. However, it feels sort of jumbled and confusing when reading (especially to someone less familiar with economics and finance). I read about the economy and finances all the time, and it's even somewhat confusing to me. So let's lay it out simply in a way that's super easy to understand. Inflation is when prices of goods and services rise and the purchasing power of your money is decreased. Is this a perfect definition? Probably not, but it gets the point across without too much mumbo jumbo.  

To further illustrate inflation, let's have an example! Imagine you go to the store, and you can buy ten oranges for $10, which makes the price of each orange $1. A year later, you go to the store and try to buy ten more oranges, but the cost of the oranges has gone up. Now your total is $15, meaning the price of each orange was $1.50. The price of oranges increasing means that you can't purchase the same amount of oranges (10) for the same amount of money ($10 initially and $15 currently). In this scenario, the price of oranges (and presumably other goods and services) has increased significantly, and this price increase is due to inflation!

How Could Inflation Affect You?

Inflation could affect you and your financial plan in a number of ways. Perhaps the most prominent and immediate effect of inflation is the rising cost of goods and services. During times of heavy inflation, you'll notice the price of essential goods like gas and groceries rise. It also causes the price of entertainment to increase over time. If you've ever heard an elder relative talk about how "it used to only cost a quarter to see a movie at the theater," they aren't lying. In 1935 the average cost of a movie ticket was $.25, while it costs an average of $9.16 today. 

Rapid inflation can also pose a more long-term risk for those who save and invest their money. As I've stated, with inflation comes decreased purchasing power. This means that money saved could spread thinner over time. While it's a scary thought that your money could be worth less in the future, inflation is something that we should all keep in mind and plan for when creating a savings (especially those preparing for retirement). 

What Causes Inflation?

Several things can cause inflation. Demand-pull inflation occurs when there is more demand than products or services, causing businesses to raise prices. Cost-push inflation happens when rising production/manufacturing makes it more expensive for companies to create, which also causes them to increase their prices. Government economic, foreign, or even regulatory policy can create external pricing pressure. 

These are only three examples, but the list of things that could cause inflation goes on and on. Of course, the Federal Reserve and Treasury also have a hand in inflation. It's theorized by many economists that an ideal rate of inflation is right around 2%, and the government does its best through various monetary policies to keep inflation around that rate. 

How to Calculate Inflation 

For simplicity, our example focused on one good (oranges); however, in the real world, inflation isn't localized to one good or service. Instead, inflation in the real world is measured using something called the consumer price index. According to Investopedia, "The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care."

To calculate inflation, we must take two measures of CPI at two points in time. Let's say we take the CPI of a basket of goods for August 15th, 2020 (x) and August 15th, 2021 (y). To calculate the rate of inflation with these two numbers, we will simply use this formula: y-x/x*100

Let's use hypothetical (very simple) numbers as an example. Imagine that our CPI for August 15th, 2020 is $1, and in 2021, it is $2. First, we subtract 2-1, which equals 1. Next, we divide 1/1, which equals 1. And finally, we multiply by 100, which equals 100. This means we had a (very alarming) 100% inflation rate from August 15th, 2020, to 2021. Thankfully these numbers are hypothetical. 

Other Forms of Inflation

Other forms of inflation include hyperinflation and stagflation. Hyperinflation is defined as when prices rise 50% or more each month. This causes severe and immediate problems for countries and their citizens. Hyperinflation effectively renders a country's currency useless as the price of goods and services rise at alarmingly fast rates. Stagflation occurs when inflation is high, the economy's growth is slow (or stagnant), and unemployment rises or remains high. Hyperinflation and stagflation are very dangerous positions for a nation's economy and can be very difficult to bounce back from. 

A CERTIFIED FINANCIAL PLANNER™ Can Help You Make Plan That Includes Inflation

While it can be challenging to predict, inflation happens. Though sometimes unexpected, a certain amount of inflation is expected in an economy, and the best way to deal with inflation is to plan for the future! While it's impossible to plan for unexpected inflation, a proper financial plan can account for and take some guesswork out of the equation. 

If you'd like to learn more about how you can account for inflation in your financial plan, please, feel free to call or email to schedule an appointment with me. Together we can create a financial plan that helps you plan as accurately as possible for your financial future. 

Until next time...this is Melissa Making Cents!

Melissa Anne Cox, CERTIFIED FINANCIAL PLANNER™, is also a College Planning and Student Loan Advisor and Financial Coach in Dallas, Texas.