Inflation and Why it Matters

A simple explanation of how inflation affects purchasing power.

Inflation is big news lately due to its recent rise. But what exactly is inflation, and how does it affect our everyday lives?

What Is Inflation?

Inflation is a rise in the cost of a broad range of consumer goods and services across multiple industries like gas, food and housing. Inflation makes your money worth less, so you’ll have to spend more for the same goods and services. In short, when inflation increases, your purchasing power decreases.

But inflation isn’t necessarily bad. Some inflation is good for the economy. If inflation is forecasted, people often make more purchases to avoid future price increases. This spending increases demand, which increases production. The U.S. Federal Reserve likes inflation to be around 2% for “maximum employment and price stability” in our economy.¹

In the United States, according to the September 14, 2021 inflation report from the Consumer Price Index, inflation over the past 12 months ending August 2021 is 5.3%. If you eliminate food and gas, it’s 4%, which is still 2% over the Federal Reserve’s target.²

How Does Inflation Affect the Value of My Money?

Besides keeping your money safe, inflation is a big reason why you shouldn’t stash cash in a shoebox or under your pillow. That money isn’t earning dividends or interest, so it loses value over time.

The same goes for an account that pays a low interest rate. Your money may be safe in an account that pays .5% annually, but if the inflation rate is 2%, your money is losing 1.5% of its purchasing power each year. The economist Milton Friedman refers to this effect as a tax on savings. However, this “tax” may actually be worth it to you in order to keep your money safe while it’s accessible.

You can use the same math with your paycheck. Let’s say you received a 2% raise last year. Great, right? Maybe not. If the inflation rate that same year was 3%, you received a pay increase, but your economic buying power decreased.

Inflation and Retirement

Inflation is something to keep in mind when planning for retirement. If you’re 30 years old and your current contribution rate is expected to give you, say, $500,000 in today’s dollars at retirement, what will the nominal value (value adjusted for inflation) of that $500,000 be in 35 years? To get today’s purchasing power of $500,000 when you retire, you’ll probably want to increase your contributions.

Many retirement calculators found online let you input different inflation rates so you can estimate the amount you’ll need to save to be able to retire the way you want. However, it’s best to consult with a financial advisor like the ones at Summit Retirement & Investment Services* to determine the best retirement savings plan for you and your goals.

Test your knowledge of financial basics by taking this quiz.

1. Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/faqs/what-economic-goals-does-federal-reserve-seek-to-achieve-through-monetary-policy.htm
2. U.S. Bureau of Labor Statistics, Consumer Price Index Summary, https://www.bls.gov/news.release/cpi.nr0.htm

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FR-3798369.1-0921-1023

Cynthia Kolko, The Summit Federal Credit Union.