Most people, including many economic experts, were caught off guard by the recent surge in inflation. That’s not surprising since most people alive today have never really experienced high, sustained inflation. You could say that everyone from investors to the Federal Reserve Board had become complacent over it. But, thus far, the shock of rising prices has been felt far and wide, and it can be especially troubling over the long-term as it begins to erode your future purchasing power. Neglecting to account for an inflationary resurgence in your long-term planning could be devastating to your finances.
When most people think about inflation, it’s in terms of the higher prices they pay for groceries and gas. Those are the dollars you are spending today, which economists refer to as ‘nominal’ dollars. It’s the money sitting in your checking account to be spent now on the things you need. But in 10 or 20 years from now, the money you’ll be spending will be based on ‘real’ dollars because it takes into account the impact of inflation on the value of those future dollars, also referred to as your ‘real’ purchasing power.
The problem with thinking of your money in terms of nominal dollars as they are used today is that it allows you to believe that your money has a fixed value over time, even though inflation is constantly devaluing it. That’s what economists refer to as “the money illusion,” which can be dangerous when thinking about your future spending needs.
Inflation Erodes Purchasing Power
The net effect of inflation is that it erodes your purchasing power over time, so the dollars you have today will be worth less in the future. Said another way, the dollars you have today will not buy you the same amount of goods in the future. That can be particularly damaging for people near or in retirement. Even at a moderately low inflation rate of 3%, it would cut your purchasing power in half twenty-three years from now.
When inflation surges, as it has in recent months, the halving of your purchasing power is accelerated. For example, the current nearly 7% inflation rate will cut your purchasing power in half in about ten years. That means you would need to spend double of dollars it takes today to buy 10 gallons of gas or a basket of groceries.
Inflation Eats Away At Your Savings
The money you have safely tucked away in savings loses value if the interest earnings are not keeping pace with inflation. With inflation running around 7% and your savings earning less than a half percent, your account is losing six and a half percent due to inflation.
Preparing Your Finances For Inflation
When planning for your long-term goals, it’s essential to be aware of the money illusion, which can deceive you into thinking you are better off than you actually are. If you don’t account for the impact of inflation in quantifying future goals, creating future spending plans, and developing your investment strategies, you could find yourself losing ground at a critical time in your life.
Here are some critical areas of your finances to review to guard against inflation:
Variable-rate debt: Higher inflation is typically accompanied by higher interest rates. Higher interest rates will impact variable-rate debt, such as credit cards, personal and student loans and adjustable-rate mortgages (ARMS). If you have variable-rate debt, it would be essential to freeze your debt costs by converting it to fixed-rate debt wherever you can or paying it off as soon as you can.
Insurance coverage: Higher inflation often translates to higher home prices. Make sure your replacement coverage is keeping pace with your rising home value. Review other coverages, such as long-term care, disability income and life insurance to ensure your protection keeps pace with rising costs and wages.
Fixed income investments: Fixed income investments, such as corporate and government bonds, tend to perform poorly in an inflationary environment. The low yields on bonds can’t keep pace with inflation and, as interest rates rise, their prices will decline. The possible good news is that rising interest rates could lead to higher yields on newly issued bonds, making them more attractive as fixed-income vehicles.
Retirement savings: Planning for retirement without accounting for inflation could result in a bad outcome for retirees. If your retirement goal is to save enough to generate $50,000 a year in today’s dollars, it may be worth far less in real dollars due to loss of purchasing power. Be sure to factor in inflation during your savings years and throughout your retirement.
To many, the current high inflation may seem like a new phenomenon. But there has always been inflation. While you can’t control it, you can mitigate its impact on your long-term finances through proper planning steps.