What is Inflation?
Inflation is the economy-wide rise in prices from one year to the next. Over the past century, the average rate of annual inflation in the United States has been around 3.30%, meaning that on average consumer prices have risen by this amount every year. While we feel this in our pocketbooks when we go to the grocery store, it is also important to understand how inflation impacts our investments and subsequent wealth.
There are different causes of inflation. A rise in commodity prices will increase the production costs for manufacturing, putting upward pressures on prices. This is known as cost-push inflation. The pressures can come from rising consumer demand as well. When consumer confidence is high, the demand for goods will increase and drive prices up. This phenomenon is known as demand-pull inflation.
Central banks try to control inflation by setting interest rates, or the rate at which banks access money. When concerns of inflation get too high, central banks will raise interest rates in order to try and keep inflation under control. Since 2012, the U.S. Federal Reserve System (also known as The Fed) has had a mandate to keep inflation at 2% annually.
Inflation and Investments
There is a direct connection between inflation and your investments. Starting with the most obvious, your investment strategy should at the very least try to outpace inflation. In other words, if your savings account is providing you with a 2% interest rate and inflation is at 3%, your money is losing value from this particular savings account.
Periods of high inflation are by-and-large connected to high interest rates, as central banks will increase rates in order to try and tamp down on inflation. This should enter into your considerations when thinking about where to invest your monies.
One aspect to consider is that stocks tend to be a good investment during times of high inflation, as their historical growth has outpaced inflation. For those not interested in purchasing individual equities, index funds can be a good option. Index funds are designed to mimic the behavior of a particular market by compiling a broad array of different stocks and bonds.
Another consideration is that the money that you keep in savings accounts and in certificates of deposits, on the other hand, will likely decrease in value during periods of high inflation. If you expect interest rates to rise, avoid purchasing long-term certificates of deposits (also known as CDs). CDs offer higher interest rates in exchange for keeping your money untouched for pre-defined periods of time. However, these investments will lock you into interest rates that will likely lose value as better options become available.
Every option you choose will feel the effects of inflation (or lack thereof), so it is important to make sure to include these in your considerations when making an investment decision.
Purchasing a House During Periods of High Inflation
Along with the cost of other goods, the price of houses will also tend to rise during periods of inflation. This increase, along with the expected rise in interest rates for borrowers, can make it more difficult to purchase a house.
However, there are other factors to consider. The first and most important is to understand your financial situation, and whether or not you are ready to take on the obligations of being a homeowner. If you have already purchased a house, your asking price can increase due to the surrounding rise in property values, giving you more monies at your disposal.
As previously discussed, periods of high inflation usually give way to increased interest rates and higher costs for borrowers. Locking in a fixed-rate mortgage prior to this subsequent rise in rates will save you money. The issue, as is the case with every type of investment, is that no one can predict with absolute certainty the future of the housing market, the actions of the Fed, or the rate of inflation.
Use the TipRanks’ mortgage calculator to experiment with different down payments, loan tenures, and interest rates to get a sense of your expected monthly mortgage payments at current rates and what this means for the overall cost of your housing loan.
Conclusion: How to Think About Inflation
It is important to understand how current and future levels of inflation can influence your investments. However, while inflation will impact your investments, your overall investment strategy should start with defining your investment goals. Once you have evaluated your current financial situation and defined your long-term horizon, there are a number of different types of investments and factors to consider.
Stocks, index funds, savings accounts, and certificates of deposit all have their benefits and disadvantages. In periods of high inflation, stocks can help provide a hedge against inflation. When inflation is lower, locking in a relatively high interest rate in a certificate of deposit might make the most sense. Whatever strategy you decide upon, make sure it is consistent with your long-term outlook, meshes with your financial goals, and takes a number of considerations into account. Inflation should be one of them.
Learn money management, and use data-driven stock insights with TipRanks.
