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Are you ready for higher inflation rates? Because we may see just that very soon.
The ongoing COVID-19 pandemic has already had a profound impact on the world and all of our lives. It is still affecting the entire world in ways many of us have never seen before. It proves to be a continual destabilizing threat to the global economy.
Economies have shut down and despite the government’s best effort to reopen the economy, many have struggled. Over 40 million people in the US are newly unemployed. The stock market dropped 30% and then rebounded shortly after.
It has been one crazy roller coaster of a ride within the last few months. In the US, economies are slowly starting to reopen. Just when things were about to look better, there is now a resurgence of COVID-19 cases across the nation.
And things may just get a little worse.
The Federal Reserve is planning to ramp up inflation very soon to inject money into the economy and keep it out of a deep recession. This will no doubt have a major impact on all of us. You can read more about it here.
So what does this mean and how does this affect all of us?
Let’s first look at inflation and deflation, and how they affect the economy.
Economic Inflation and Deflation
Inflation is when the cost of goods and services goes up while the nominal value of our money stays the same. This means the cost of everyday items will soon be more expensive, which means our money has less buying power. In other words, we are “losing” money as inflation goes up.
Now you may be wondering why on earth would the Federal Reserve want to increase inflation during a pandemic when many of us are so tight on cash.
This all comes down to deflation, which is the opposite of inflation. With deflation, the price of goods and services goes down and the value (nominal) of our money stays the same. This means the longer we wait to buy something, the cheaper it becomes because our money has more purchasing power in the future.
You may be thinking, “Wait a minute…isn’t that a good thing?”
Well, not quite. It could actually be a disaster for all of us.
In a deflationary economy, what happens is that people stop spending money because they want the value of their money to go up. They tend to hold onto their money so that they can purchase things at a “cheaper” price in the future. When this happens, a vicious cycle is created where demand goes down, causing prices to go down alongside it in order to incentivize people to spend money. This further means more people will be holding onto their money as they continue to see prices go down. With less money going around, businesses have to scale back because they are not making as much money, which in turn causes them to reduce their employees. As a result, so many people end up losing their jobs or getting laid off as you have already seen or may have personally experienced. When people lose their jobs they have even less money to spend.
All of this creates a vicious cycle of endless deflation, causing the economy to go into a deep recession, which is not good for any of us.
Since people are not spending money amid the pandemic, there is no upward pressure for prices to increase and inflation to occur. If this keeps up, the economy will eventually enter a recession. Once deflation starts, it becomes very difficult to stop unless immediate steps are taken to stop it from happening. in the first place.
This is where we are at right now.
According to the US Labor Department data published on July 14, 2020, the annual inflation rate for the US is currently 0.6% as of June 2020 compared to 0.1% previously. This means for every $100 you kept in cash, you’ve only lost $0.60 of value over the last year.
And that is approaching a seriously dangerous value – once it falls below 0% we will have deflation. In an effort to prevent deflation and the economy from falling into a recession, the Federal Reserve wants to increase inflation. Normally the Federal Reserve would just print more money and put it into the economy to increase inflation, but this time around it is not enough because too many people are not spending. No matter how much money is printed, there will not be enough to cause inflation.
Why Do We Need Inflation?
You may be wondering why we need inflation and why can’t the value of money stay the same every single year. Well, inflation on a controlled scale is actually a good thing and here’s why.
If people know that their money will be worth a little less in the future, it’s going to incentivize them to spend it now. Otherwise, if they wait too long they can only afford less of whatever they want to purchase. This is good for the economy as there will be more money poured into it. Without people spending money or spending less, the economy will slowly drop into a recession like it is now.
A good economy is good for businesses. Business revenue will grow and as a result, employers can afford to increase wages a little more each and every year. This is good because it helps you stay on top of or just enough to keep pace with inflation. Otherwise you will likely get little to no increase is your wages or salary every year. And who doesn’t want a raise?
Inflation also increases interest rates for things such as mortgages and auto loans. This facilitates borrowing and spending money now to lock in lower interest rates and avoid higher rates in the future, which in turn helps the economy grow.
To sum it all up, the more money people spend, the better it is for the economy. The better the economy, the more money circulates back to us. And this cannot happen without inflation.
What Does This Mean For Us?
To put it simply, this means that if you are holding onto your money, you are going to lose even more money than you have in the past year or so. As you can see from the graph below, the average interest rate for the past 10 years is about 2%, which is where the Federal Reserve aims to keep it at each and every year. By comparison, the 0.6% inflation rate we have now is actually quite low, thus allowing us to “keep” more of our money.
The Federal Reserve is now committed to bring the inflation rate back up to the 2% target. This means that for every $100 you have in cash, you will lose $2 in value. It also means that if you get a 2% raise, you essentially “didn’t” get a raise because of inflation. If you get 3%, which is typically the average, then you’ll be barely edging out inflation.
An increase in inflation also means an increase in interest rates. As you can see from the red line in the graph below, it more or less mirrors the inflation line (blue line). This means if you have been saving a lot of money the past few years and are thinking about purchasing a home or taking out a loan for whatever reason, now is the time to lock in the low interest rates. Mortgage interest rates have dropped to 2.8% – 3% for a 30-year fixed rate loan, which is the lowest ever. That means you can lock in that rate for 30 years!
The value of assets like real estate and stocks may continue to go up in value with inflation. Goldman Sachs recently reported that the stock market rally may not have been optimism on growth, but rather optimism on inflation. This could explain the quick stock market rebound and growth in the value of stocks. Investors are putting money into the stock market, buying stocks not because they are undervalued, but because they are worried that inflation is going to drive up the prices of stocks. So investors are spending money now by investing in stocks when the price is low and hope to maximize their gains as the value goes up alongside inflation.
If you ever considered investing, now may be a good time to do so. However there is always risk involved. The stock market may go down instead in the immediate future so I only recommend investing in the stock market if you have an emergency fund with preferably 6 to 12 months worth of expenses and you have extra money leftover.
Final Thoughts
Inflation is not a bad thing. I know many of us may not like inflation but we need it for the economy to grow.
I also know that many of us are afraid of losing money, which is one of the main reasons why many of us decide not to do anything with it except keep it in our bank accounts. However, by not doing anything and holding onto your money, you are losing money to inflation. So in essence, we end up losing money regardless.
A great way to combat inflation is to start putting your money in a high-yield savings account where your money will grow by gaining interest. It’s not going to be much, especially since interest rates are getting lower and lower due to the pandemic, but at least it’s something and it’s a good place to start. At the current average interest rate of 0.8%, you will still barely edge out inflation.
Another good way to beat inflation is to invest your money in the stock market. Remember there’s always risk involved, but the risk can be minimized through investing in safe stocks such as index funds. Again, I only recommend investing in the stock market if you have an emergency fund with preferably 6 to 12 months worth of expenses and you have extra money leftover.
So what is your plan to prepare for the potential increase in inflation?
If you do not have a plan or if you do not know where to begin, a great place to start is to learn the basics of how money works. My free Personal Finance 101 email course will help you learn and understand the basics, including the many ways to invest. If you are interested, you can sign up here.
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