Americans Don’t Understand Inflation — This Is How It Actually Affects Your Money
Inflation — it’s a word you hear frequently, but do you really understand what it means?
What most people know about inflation is that it makes things more expensive. A simple definition of inflation is that it’s the increase in the cost of goods and services over a time period in an economy, which is usually expressed as a yearly percentage. Inflation rates are measured by price indexes, including the consumer price index by the Bureau of Labor Statistics and the personal consumption expenditures price index from the Bureau of Economic Analysis.
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The main effects of inflation are better interest rates for savings accounts and higher costs of living, but there are several more nuanced effects to watch out for as you manage your money. Increasing your understanding about the different types of inflation and how they could impact your life both positively and negatively can help you make better financial decisions, especially when it comes to protecting your money now and in the long run.
Inflation Can Be Confusing
According to GOBankingRates’ 2024 Financial Literacy Survey, out of all current hot money topics — inflation, interest rates, Social Security and taxes — 38% of Americans find inflation to be the most confusing. Here’s a breakdown of the percentage of each age group that finds inflation most confusing:
18- to 24-year-olds: 29%
25- to 34-year-olds: 42%
35- to 44-year-olds: 41%
45- to 54-year-olds: 45%
55- to 64-year-olds: 35%
65 and over: 32%
Overall, respondents ages 18-24 and those 65 and over — members of the youngest and oldest age groups — find inflation to be less confusing than the other age groups. Respondents ages 45-54 find inflation to be the most confusing of all generations, followed people who are 25-34. Additionally, 40% of women versus 35% of men said that inflation was the most confusing of current hot money topics.
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How Inflation Affects Your Money
Not all outcomes of inflation are bad. In fact, maintaining a healthy rate of inflation is good for the economy. Here are some of the positive and negative effects of inflation:
Positive: You’ll Get Better Savings Account Rates
Investors with short-term goals might invest in a high-interest savings account if they think they would need access to their funds in the near future. If this sounds like you, your short-term savings could get a boost because increasing inflation often prompts the Federal Reserve to raise interest rates, and banks, in turn, often raise the rates they pay on savings deposits. So you could benefit from a better return on money sitting in your cash or savings account.
Negative: Borrowing Becomes More Expensive
But those aren’t the only rates banks raise. When the Federal Reserve raises interest rates, it makes it more expensive for banks to borrow money from one another. These increased rates are then passed on to individual and business borrowers. The bottom line is that higher inflation means higher interest rates on the money you borrow — and less money in your pocket.
Negative: You’ll Pay More for Stuff
With inflation, prices of pretty much everything start to rise. Medical care and prices for prescription drugs could increase, and your rent could also go up. And unless your paycheck goes up at least as much as the inflation rate, you’ll be trying to pay for the increased costs of items on the same income, so inflation can be tough on the wallet — especially during hyperinflation.
Hyperinflation occurs when very high rates of inflation spiral out of control. Also keep an eye out for the phrase “core inflation,” which is an inflation measurement that excludes certain volatile markets like energy and food.
On the other hand, if you see the term “all-items Consumer Price Index,” note that it’s a measure of economy-wide inflation. The all-items Consumer Price Index has risen 3.2% from a year ago, according to the Bureau of Labor Statistics.
Positive: You Might Receive a Pay Raise or Find a Higher-Paying Job
As inflation pushes the price of goods and services higher, it can also be positively correlated with higher wages. [4] Not only do companies find they need to offer better salaries to new hires, they’ll also have to pay more attention to fairly compensating their existing employees in order to retain the talent they already have. This means if you’ve been looking around for a new job as inflation is rising, you could get paid more at a new company, but you might also have an increased opportunity for a raise.
Negative: Your Mortgage Payment Could Increase
Borrowers who have an adjustable-rate mortgage might find that an uncomfortable effect of inflation is a higher interest rate when their mortgage is “adjusted.” Adjustable-rate mortgages have a “teaser” rate in effect for a set amount of time, such as five years, as seen with a 5/1 ARM. After five years, however, the rate “adjusts” every year. If inflation causes interest rates to rise during an adjustment period, the interest on your mortgage loan will increase, and so will your monthly payments.
Positive: You Might Receive a Cost-of-Living Adjustment
Even if you don’t have the money to invest in stocks, gold or other assets that might be positively impacted by rising inflation, a little inflation could still benefit your financial situation. Recipients of Social Security and Supplemental Security Income could see an increase in their monthly payments when the Consumer Price Index, one of the inflation measures, goes up. This is called a cost-of-living adjustment, and it means you’ll have a few more dollars to cover your monthly budget.
Negative: Your Long-Term Savings Might Erode
For investors who count long-term, conservative investments as a significant part of their net assets, inflation can be a dirty word. This is because these traditionally safe investments, like bonds, often require investors to lock into a guaranteed rate for a long time. Inflation creates a situation where these long-term investments that pay a low interest rate have decreased buying power because inflation pushes up the price of goods and services.
How To Protect Your Money From Inflation
The best way to combat the consequences of inflation is to invest in a balanced portfolio that includes some portion of long-term capital investments, like equity stocks. Ideally, these equities will increase in value over time and above the inflation rate.
Though investing in more conservative investments such as bonds might be a safer way to go, some experts disagree because, in times of higher inflation, the low rate of safer investments could be below the inflation rate, which means your future buying power is slowly getting eaten away.
Instead, consider protecting your money from inflation by investing in the following:
Treasury Inflation-Protected Securities: TIPS are bonds, but they are backed by the government and their return is linked to inflation through the CPI.
Blue chip stocks: These offer dividends and capital appreciation over the long term.
Think about how an increase or decrease in inflation could impact your life — including your grocery bill, short-term savings and retirement savings, as well as your earnings and vacation plans. Understanding how inflation works can help you make wiser financial choices so you make the best decisions for your family.
Sarita Harbour contributed to the reporting for this article.
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This article originally appeared on GOBankingRates.com: Americans Don’t Understand Inflation — This Is How It Actually Affects Your Money
