Question: How Does Inflation Impact My Life?
Answer: Inflation usually hurts your buying power. That's because rising prices means you have to pay more for the same goods and services. Inflation can help you if you are the lucky recipient of income inflation. You can also benefit from asset inflation, such as in housing or stocks, if you own that asset before the price rises. However, if your income increases at a slower rate than general inflation, your buying power declines even if you are making more. Furthermore, many people can get hurt by an asset bubble if they try to time it, and buy right when the bubble is about to burst. In general, inflation's main consequence is a subtle reduction in your standard of living.
Inflation doesn't affect everything equally. Gas prices can double while your home loses value. This is exactly what happened during the financial crisis of 2008. There was deflation in home prices, which fell 31.8%. Meanwhile, inflation in oil prices, which reached an all-time high of $148 a barrel. Since oil prices drive gas prices, this made the cost of gas head for $5 a gallon. Driving to work became even more expensive, and stressful, at a time when many workers were worried about even keeping their job.
Once the Federal Reserve started quantitative easing and the Federal government enacted the economic stimulus plan to end the recession, investors grew worried about inflation. As a result, they bought gold. This eventually drove the price of gold to an all-time record of $1,895 an ounce on September 5, 2011. In this instance, there was inflation in gold and oil prices, with deflation in housing prices and personal income.
Inflation has another bad side-effect...once people start to expect inflation, they will spend now rather than later. That's because they know things will only cost more later. This consumer spending heats up the economy even more, leading to more and more inflation. This situation is known as spiraling inflation because it spirals out of control.
If inflation reaches the double-digits, it's known as hyperinflation. If this happens, you will need a wheelbarrow to buy a loaf of bread. Fortunately, it happens very rarely, and only when the government is so irresponsible that it prints money without regard to the inflation rate. It happened in Germany in the 1920s, and in Zimbabwe in the 2000s. If inflation ever approaches the double-digits, your best defense is to buy gold or any currency that isn't pegged to the dollar. (Or become a baker!)
Effect of Inflation on Retirement Planning
The combination of inflation in some asset classes, and deflation in others, makes financial planning more difficult. Rules of thumb no longer apply. One of the reasons government economists didn't do more to head off the recession was because no one could believe that housing prices could really fall.
Inflation is really bad for your retirement planning because your target has to keep getting higher and higher to pay for the same quality of life. In other words, your savings will buy less. As a result, you will need to save more today to pay for higher priced goods and services in the future. Since everything you buy today costs more, so you have less left-over income available to save.
Impact of Inflation on Treasury Bonds
Inflation is important if you are holding bonds or Treasury notes. These fixed price assets only give a fixed interest each year. As inflation spirals faster than the return on these assets, they become less valuable. As they become less valuable, people rush to sell them, further depreciating their value. As their value becomes lower, the U.S. government is forced to offer higher Treasury yields to sell them at all. This increases most mortgage interest rates.
This lowers the value of your investments. It also increases the cost to the Federal government of financing the U.S. debt by raising the interest payments each year. The additional budget expense needs to be offset by a cut in the discretionary budget, an increase in taxes, or further deficit spending. All of those are contractionary fiscal policies, and will slow economic growth. That translates into a lower standard of living for you. Article updated February 25, 2014