Gain a Better Understanding of Inflation

presented by Doble LeBranti Financial Group

Gain a Better Understanding of Inflation

Over the past year, we’ve seen significant price increases caused by pandemic-related shutdowns, supply chain disruptions, labor shortages, the war in Ukraine, and a host of other influences. The Consumer Price Index (CPI), a key measure of inflation, reached 9.1 percent in June 2022, setting a 40-year high. Prices for almost everything, including used cars, housing, gas, and groceries, have been prominently affected.

Below, we’ve answered common questions to help you better understand inflation, its influence on the economy, and how it can affect your retirement planning efforts.

What Is Inflation?

Inflation is the loss of purchasing power over time. It means your dollar won’t go as far tomorrow as it does today.

How Is Inflation Measured?

There are several measures that investors can use to track inflation. In the U.S., the CPI, which reflects retail prices of goods and services, including housing costs, transportation, and health care, is the most widely followed indicator.

What Causes Inflation?

Although inflation has many causes, it’s important to understand two basic concepts:

Cost-push inflation. This occurs when it costs a company more to provide a good or service (perhaps because of an increase in the cost of raw materials), causing it to raise prices to compensate. Those increased costs push the prices of what we buy higher.

Demand-pull inflation. This occurs when our desire to buy things—our demand—is greater than what companies can provide—their supply. When something is in short supply, people are willing to pay more to get it. In this situation, consumers pull prices higher.

How Does the Government Manage Inflation?

At a high level, the Federal Reserve (Fed) can lower short-term rates, which encourages banks to borrow from a central bank and from one another, effectively increasing the money supply in the economy. Banks, in turn, make more loans to businesses and consumers, stimulating spending and overall economic activity. As economic growth picks up, inflation generally increases. Raising short-term rates has the opposite effect: it discourages borrowing, decreases the money supply, slows economic activity, and reduces inflation.

How Can Interest Rate Hikes Affect My Finances?

The Fed doesn’t set interest rates on credit cards, mortgages, auto loans, and savings accounts, but its actions influence them. Here are three significant ways interest rate hikes can affect your finances, along with tips for managing them:

Credit cards. Most cards charge a variable rate tied to the bank’s prime rate, which is the rate banks charge their best customers. (Many consumers pay an additional rate on top of prime, based on their credit profile.) Banks typically raise their prime rate quickly after the Fed boosts its key rate. Consider starting to pay down any balance before rates get much higher, focusing on the card with the highest rate first.

Mortgages. If you have a fixed-rate mortgage, your monthly payments won’t change. If you refinanced in the past few years and locked in a rate in the 2–3 percent range, you had excellent timing. If you have an adjustable-rate mortgage (ARM), however, you may be faced with larger payments, depending on the terms of your loan. If you have an ARM, budget for higher payments.

Auto loans. With prices increasing dramatically in the past two years, it’s already more expensive to buy a new or used car. Unfortunately, if you’re planning on financing the purchase of a vehicle in the near future, you’ll need to add in the higher cost of borrowing. A sizable down payment will lower your monthly payments and could help secure a lower interest rate.

How Does Inflation Affect My Investments?

Your real rate of return is the return on your investment minus the inflation rate. That gives you a better sense of the purchasing power of the money you earn from investments. If your investment portfolio earns an 8 percent rate of return in a particular year, for example, and the inflation rate is 3 percent, your real rate of return is 5 percent.

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