What Is Inflation and Why Is It Bad?

There are many questions you have about inflation. In this article, we will answer four questions. First, what is inflation? Once you know what inflation is, you will need to know what causes inflation. We close by sharing the dangers of inflation and how to protect yourself from it. The answer to these questions are more important now than ever with inflation at a 40-year high.

What is inflation?

It is essential to understand inflation because inflation is one of the five key risks to retirement planning. It is the reason you cannot simply hide your money in a mattress. Inflation is your purchasing power decreasing over time. Purchasing power is your ability to buy goods and services. Therefore, inflation is a fancy of way of saying it costs you more money to purchase the same goods and services.

The dangers of inflation?

As a kid, I recall my parents filling up their gas tank for $0.99 per gallon. That price went up each year by a few cents. Nothing alarming. Just seemed to be the natural order of things. It was not until the 2000’s when gas seemed to go up exponentially. There were many factors during that time as to why the price of gas was doubling over the span of several months. Now we are in a time where gas is exponentially increasing again. Gas is now over $5.00 per gallon. What is it that is causing the price of gas to increase so quickly?

Understanding inflation is important to your financial success because as your purchasing power decreases, you must account for that in your financial plan. Studies show approximately every 17 years your purchasing power cuts in half. Which is a fancy way of saying, what use to cost you $100, will cost you $200 to purchase the same items in 17 years. Which is important to your retirement plan, because you need to maintain your lifestyle.

Three causes of inflation

The three causes of inflation are (1) Demand-Pull; (2) Cost-Pull; and (3) Built-In.

1. Demand-Pull

Demand-Pull inflation is when there is so much demand for a product, the company making the product has the option to increase their price. The company knows they are going to run out of inventory, so they can offer their goods at a higher price.

During hurricane season the price of non-perishable goods, such as water and gas tends to increase. In the past few years, you may have noticed the same inflationary increases during the pandemic. The price of toilet paper and sanitizer both increased significantly during the pademic.

If you love sports like I do, then you noticed the same thing there. The price of a ticket to the Superbowl is already higher than any other game because of the demand. However, people resell their Superbowl tickets for an even higher price because there are only so many seats in the stadium.

Companies like Apple take advantage of the demand-pull by only producing so many iPhones. They can charge a much higher price for their products because people know they are going to sell out. Even around Christmas time, people will resell the limited supply items for a higher price.

2. Cost-Pull

The next type of inflation is Cost-Pull. Cost-Pull is when the cost of the item increases. In my price of gas increasing example, there could be regulatory changes that increase the price of oil. The oil companies are unlikely to allow their profits to decrease. Therefore, the oil companies will increase their price and pass those higher costs to their consumers. There could be a logistical change where one oil-well dried up and the transportation cost from the new oil-well is much higher. As a result, the company will increase their prices so their profit margins don’t decrease.

Cost-Pull inflation is anything that increases the cost of the good or service. This could be related to how much they pay their employees to produce the good. An example would be an increase in minimum wage could increase the cost of the goods produced by the company. The cost can also be driven by an increase in materials from other companies in the supply chain. In our current environment, the cost of new-build homes have significantly increased. There are some signs the price of lumber and other building materials have raised noticeably.?

3. Built-In

The last form of inflation is built-in inflation. We expect inflation to be about 3% per year. Because this is the amount we expect, companies are comfortable increasing their rates by a small percentage over time. The good news is most jobs will increase wages each year to make sure they are keeping up with inflation. As a result, your purchasing power is unchanged year over year.

Simple ways to combat inflation

If you maintain this principle when it comes to investing, you will be able to stave off inflationary pressures. What this means is you should invest your money in places that at-least grow with inflation each year. This will ensure you maintain your purchasing power throughout your retirement. If your investments are not keeping up with inflation, it is the same as you losing 3% each year. Overtime, this becomes unsustainable and you cannot maintain your retirement lifestyle.

Final thoughts

We must take inflation seriously as it has a direct impact on your ability to maintain your lifestyle in the future. Whether you want to retire at 35 or 65, you cannot overlook inflation. The three main causes of inflation are built-in, demand-pull, and cost-pull. Inflation’s historical average has been around 3% per year. You will have some years with higher inflation and others years with lower inflation. Just make sure you are protecting your future lifestyle by maintaining a return that beats inflation’s historical average.