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Inflation is an economic term you've likely heard thrown around in political and financial news. You may have also noticed it in your everyday life as the costs of raw materials like lumber, paper, oil and steel increase and your dollar doesn't buy as much as it used to when filling up your gas tank, remodeling your home or stocking your fridge.
The term "inflation" refers to the gradual increase in the price of goods and services, and the subsequent decline in the value of currency. Understanding how inflation works and what steps you can take to reduce its effect on your life can help you prepare financially as the economy ebbs and flows. Read on for tips on how to insulate yourself from inflation.
What Is Inflation?
Inflation is the measure of rising prices over a period of time, and economists determine inflation by comparing price indexes that group and track the cost of select items.
One of the most widely used measures of inflation is the Consumer Price Index (CPI), which is calculated by the U.S. Bureau of Labor Statistics and measures how the cost of a "basket" of consumer goods and services paid by urban consumers changes over time. The groups within the basket include food, housing, transportation, medical care and more. In just the past year, from June 2020 to June 2021, the index's rate of growth was 5.4%—helping to fuel inflation concerns in recent months.
As the cost of goods increases, purchasing power decreases. As an example, $1.00 in January of 2001 has the same buying power as $1.49 in January 2021—meaning that you need to spend $1.49 today to buy what a dollar could fetch two decades ago.
How to Survive the Effects of Inflation
Avoiding inflation completely is impossible, but there may be some things you can do to minimize its effect on your finances.
First, it's important to differentiate between inflation that is short-lived and inflation that lasts over a longer period. Short-lived inflation can often be attributed to supply and demand issues that drive competition and temporarily raise prices. Lasting inflation is more gradual and based on a wider variety of factors.
While both types of inflation are difficult to avoid, your strategies for dealing with each may differ. The main way to survive the impact of long-term inflation is to increase your income or invest in a way that helps you grow your money at a pace that exceeds the rate of inflation. Here are five ways to survive short- and long-term inflation.
Maintain a Diversified Portfolio of Investments
For the everyday consumer, having investments and assets that appreciate is a great way to combat the impact of inflation. Since inflation often causes the value of money to decrease, positioning your money to grow over time means that—if your investments perform well—your dollar will ideally outpace inflation.
If you have an investment portfolio and/or a 401(k), individual retirement account (IRA) or other retirement account, you'll want to make sure your investments in those accounts are diversified among stocks, bonds, index funds and other investment vehicles with varying levels of risk. Talking to an investment advisor or your company's retirement account representative can help ensure you've got a good balance of investments that will ideally outpace inflation while also mitigating your risk.
Outside of your investment portfolio and retirement account(s), picking the right investments as a hedge against inflation will require some research. Many investors believe gold and silver are a good bet as they are known to hold their value well. Investing in real estate can also be a good strategy if you have the means, because inflation also causes property values and rents to rise—a benefit for both homeowners and landlords.
Build an Emergency Fund
Outside of planning for the future with investments, one of the best ways to protect your finances is to always have reserve funds for when an emergency hits. An emergency fund is a designated savings account where you store extra cash for unexpected expenses.
While an emergency fund does not directly protect you from inflation, it can help you prepare for additional costs should temporary price fluctuations push you over budget. For example, if fuel costs surge due to market conditions, it could upend your monthly budget. Having an emergency fund in place could give you the breathing room you need until you have a chance to revise your budget.
If you have an emergency fund or are considering starting one, remember that storing your money in an account that offers some form of appreciation could help you further protect your money from devaluation. Consider opening a high-yield savings account, which allows instant access to your money while offering higher interest rates than typical savings accounts.
Review Your Budget
Since both temporary and lasting inflation will impact the cost of everyday items, it's important for you to regularly revisit your budget to ensure you're accounting for price changes over time.
If a large part of your budget goes toward items such as gas, utilities and food that can be impacted by temporary price increases, consider ways to save money in these areas when you hear that inflation might be driving prices higher.
Reconsider Large Expenses
If you're planning any large projects or purchases, such as home renovations or buying a new car, consider how inflation may impact the costs and whether any price increases are likely to be short-term or longer-term.
For example, lumber prices spiked as a result of supply chain and other issues brought on by the pandemic, but prices are already beginning to drop from recent all-time highs. Recognizing that these cost increases may be temporary, you could put off replacing your wood floors, for example, until prices cool off. If you hear rumblings of inventory shortages in areas you plan to spend, either take action immediately or start setting aside extra cash to cover possible price hikes.
Ask for a Raise
As inflation increases and the value of your dollar decreases, asking for a raise could help you keep up with the cost of living. If the cost of goods goes up over time but your pay remains the same, it may become difficult to afford your typical spending. When you increase your income, although inflation may spike the cost of everyday items, you'll know you're bringing in more money each month allowing you to cover the incremental new cost.
Though asking for a raise is a great way to secure your personal finances, remember that many companies increase wages over time in an effort to account for changes to the cost of living. Your company may have such a policy in place, so check with your employer before asking for a wage increase to cover inflation.
As always, if you're keen on protecting your personal finances over time, it's important you keep up with your credit to ensure your credit health is in a good place. You can get a free copy of your credit reports and scores from Experian.