Inflation is one of the most important economic measures for any economy. At its core, inflation is the gradual increase in prices over time. In an economy where the prices are going down, they are experiencing deflation. There are many causes of inflation in an economy, and by itself is not necessarily a bad thing. In times of rising prices, people who have saved money are hurt more than people who borrow money. This is because in the future the value of the money they have currently will be worth less in purchasing power in a market with high inflation.
Inflation Is At Historic Lows
Over the past five years, inflation has remained in check. In fact, measured over a five year span the rate of inflation for the economy of the United States is at historic lows. There are many reasons for this shift, but first of all it is important to understand how inflation is measured. The Consumer Price Index is basically a composite of different industries and sectors in the economy of the United States. This index will measure different sectors of the economy and report on how much prices are going up or down. Different sectors have different weights in the price index. For example, the technology sector continues to see pries decrease over the past twenty or thirty years. However, gas prices are much higher than they were thirty years ago. The biggest reason that inflation is so low is the Federal Reserve. The Federal Reserve sets interest rates in the United States, as we are one of the only countries without a national bank. These interest rates determine the price of borrowing money, and with the interest rates at banks near zero for several years this has helped to keep inflation down.
Low Risk Investments Are Affected By Inflation
One of the areas that are affected most by inflation are the investment vehicles that people use moving towards retirement. When investing and calculating an annual return, it is important to factor in inflation. Historically, this has hovered around three percent. In times of high inflation, it is much easier to get a relatively risk free investment that has a high yield. One example of a risk free investment is a certificate of deposit. This is essentially where a person will lend their money to a bank and over time make money off of that investment. Currently, with interest rates at historic lows, the interest rates that are paid on these risk free investments are well under one percent. For those that are approaching retirement, it is difficult to maintain a nest egg with such low interest rates if you are withdrawing from the principle. In a high inflation time, it is much easier to earn annual returns on the money invested, but the purchasing power of dollars that you currently have are hurt due to increasing prices.
Inflation is Going Up in the Future
Let’s be honest, at this point, inflation has no where to go but up. A quick look at the historical inflation rates shows an upward trend since over a century. The Federal Reserve is expected to raise interest rates within 2015, and when that happens not only will it be more expensive to take out loans but prices will go up across the economy. Although this is not necessarily a bad thing, it is important to take steps to prepare yourself financially. First of all, if you have a variable rate loan it would be a good time to go ahead and lock in a fixed rate while interest rates are so low. With balloon payments or variable interest rate loans, those interest rates have nowhere to go but up. At the end of the day, inflation is neither a good or a bad thing as there are pros and cons to inflation. However, it is important that you understand both sides and make adjustments to your financial life accordingly.