After years out of the limelight, inflation has roared back into the headlines, with percentage increases not seen in 40 years. Inflation affects you in many ways, so it makes sense to understand how it works and what you can do about it.

What Is Inflation?

Inflation causes you to lose purchasing power over time. It is a general rise in prices that reduces how much a dollar will buy. In the US, we measure inflation as the annual price change for a basket of goods and services. The Consumer Price Index (CPI) applies to urban consumers, whereas the Personal Consumption Expenditures index (PCI) measures items that people consume, including things not paid for directly (such as health care).

The Federal Reserve is in charge of controlling inflation, which usually means limiting PCI increases to no more than 2%. Modest inflation is generally good for an otherwise healthy economy, but higher levels erode your ability to buy the things you need and want. High inflation can result from supply shortages or a surplus of cash or credit in the economy. 

When consumers have more money to spend, they compete for available goods and services. Inflation is, in effect, the rationing of purchasable items through price increases. Unusual events, like the Covid-19 pandemic, can also spur inflation. 

Inflationary price bursts may fade as quickly as they appear, but they can linger for extended periods. One theory states that inflation will continue if workers demand and get compensating wage increases. Employers pass the higher wage costs onto their customers, fueling the inflationary cycle. 

How Inflation Affects You

Hyperinflation is ruinous, and high inflation is destabilizing. But the effect of moderate inflation is a hotly debated topic. Here are some ways you might feel inflation’s impact:

• Interest Rates: The Fed fights inflation by raising a key interest rate that ripples through the economy. You may first notice it as higher APRs on credit cards and loans, including personal loans and mortgages. If your loan is fixed-rate, your cost won’t go up. But if you have variable rate debt or are looking to obtain new credit, the price of borrowing will be higher. Eventually, savers may benefit from higher interest rates, although the interest paid by savings accounts and CDs is “sticky” – slow to increase.
  
  
• Wages: Over time, a hot economy creates new jobs that can result in a labor shortage. Higher wages usually follow. If you’re lucky, you’ll receive cost of living adjustments (COLAs) each year that keep up with inflation. In fact, Social Security benefits automatically incorporate annual COLAs. Minimum wage workers may feel the most benefit, but they also suffer the most pain from higher prices.
• Investments: Stocks are supposed to be one of the few investments that keep up with inflation. This rule-of-thumb may be valid as long as interest rates don’t rise too high – that is, so high that companies can no longer borrow as much as they would want. Eventually, high interest rates can harm a company’s profits and cause it to contract. This, in turn, might cause shortages, layoffs, and other destabilizing effects. Marginal companies might even go bankrupt. If you are laid off, inflation suddenly goes from a nuisance to a crisis.

Investments in fixed income securities typically lose value during inflationary times. The reason is that new bonds will pay more interest than old bonds to attract investors. The prices of seasoned bonds decline, leaving with a paper loss. If you don’t sell your bonds, you can redeem them for their face value upon maturity, but until then, you will be collecting less interest than you would from new bonds.

Variable-rate debt, inflation-adjusted bonds, and cash can benefit from higher inflation.

• Home Prices: Generally, home prices increase during inflationary times. The effect upon available stock is unclear, depending on homeowner perceptions. If you feel home prices will continue to rise, you may delay selling your home. However, if you think inflation is peaking, you might decide that now is an excellent time to sell.
  
  Rents move up with rising home prices. Some homeowners may decide to sell their homes and move to a rental, stashing the sale proceeds until the next market downturn. Others sell their homes at high prices but purchase new ones with inflated price tags.
  
  Inflation may cause some mortgage lenders to adopt less stringent standards in favor of higher income from expensive loans. As happened in 2008-2009, this type of behavior can undermine the housing market and lead to a collapse. Remedial legislation is supposed to curb this problem – we shall see.
  
  
• Retirement: Those living on a fixed income can be burnt badly by inflation, even taking Social Security COLAs into account. Simply put, your monthly income might not keep up with higher prices, threatening your lifestyle and raising fears that you’ll outlive your money. Loss of buying power is why many financial advisors urge retirees to invest part of their nest eggs in stocks as a buffer against inflation. Some advocate owning precious metals (or the stocks of their producers), as these often benefit from inflation. However, gold, silver, and platinum can have volatile price movements, so caution is warranted.

What Can You Do About Inflation?

If you think inflation will be around for some time to come, you might want to accelerate any big-ticket spending you’ve been anticipating because it will only become more expensive if you wait. 

Stocks are a good inflation hedge, which might motivate you to reallocate some of your other assets to equities. You might also consider convertible bonds and warrants as a surrogate for stocks, as they supposedly provide upside performance with less downside risk (although this is not always the case). Treasury Inflation-Protected Securities (TIPS) and US Savings I-Bonds compensate you for higher inflation, but TIPS are often overpriced. Cash in an insured account is a safe bet, but don’t expect much return on an inflation-adjusted basis. If you are aggressive, you might consider investing in real estate directly or through real estate investment trusts (REITs).

In sum, inflation can be a challenge and an opportunity. Consulting with a financial advisor can help you navigate these tricky times.