February 26, 2018

What is inflation?

As of today, in early 2018, we hear an economic term that we haven’t talked about in more than a decade: Inflation. This is causing a bit of panic in the markets, but that might just because everyone forgot what inflation is.

Let’s start with the definition of Inflation.

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Inflation is the rising price of goods and services. Simply put, when it cost more to buy groceries or put gas in your car, you’re experiencing inflation.

Is inflation good or bad?

Rising prices sounds like a bad thing. However, the reality is that inflation it’s not necessarily a bad thing.

Many times prices begin rising because the economy is improving. As a result, consumers and business want (demand) goods and services faster than they can be produced (supply), causing scarcity and price levels rise. This is referred to as a demand-pull or demand-side inflation.

At other times, prices begin rising because of the cost of goods and services production increases. As a result, this tends to force price levels up and output down, again creating scarcity. This is referred to as cost-push or supply-side inflation.

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what is inflation

What does that mean for you?

One of the biggest impacts of inflation on the individual is that your money isn’t worth as much. Your dollar doesn’t buy as much as it did pre-inflation.

When inflation first re-enters the economy, you’re unlikely to feel the pinch. This is because typically the return of inflation is triggered by the economy heating up–businesses are growing, unemployment is decreasing, and wages are increasing. This demand-side inflation is fueled by our financial success. However, this strength continues to add cash to the fire, which can send inflation to levels that begin to impact the cost of producing these goods and services and now prices are increasing, independent of our demand.

At this point, we begin to feel the pinch.

How do you beat inflation?

The natural reaction to the volatility of an economy in transition is fear. Inflation, the rising cost of food, clothing, housing, fuel, and stuff in general can create a bit of panic. This fear can encourage us to begin trying to maintain our buying power by using more credit (i.e., credit cards, personal loans, home equity loans, cash-out refinancing of mortgages) or squirreling away money into savings account, money markets, or CDs.

Both of these behaviors will put you significantly behind the inflation power curve. Credit interest rates are, by definition, always much higher than the cost of inflation and bank savings products are, by design, pegged below the rate of inflation.

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So, what can you do to stay ahead of inflation? Ride the wave of businesses making more money.  

You can execute this strategy on two fronts. First, take advantage of a tight labor market to ask for a raise, gain a promotion, or get recruited away to a bigger opportunity. Second, research and invest your money wisely in mutual funds, ETFs, or individual stocks and bonds that are earning more than the rate of inflation or even participate by starting or investing in your own business.

Questions? Comments? Talk to me on Twitter @billrice and please include a link to this article.

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