Inflation can have a big impact on your personal finances. However, as the old saying goes, forewarned is forearmed. By understanding how inflation works and how to prepare for periods of rising prices, you can better protect your hard-earned money the next time inflation heads north.
Understanding Inflation: The Basics
First, let's break down the basics of what inflation is, what causes it, and how it affects consumers.
What Is Inflation?
Simply put, inflation is a gradual increase in prices. However, inflation doesn't refer to just one or two items or services becoming more expensive. Instead, inflation refers to a broad increase in prices across an industry or even an entire economy.
When inflation grows quickly, it noticeably decreases the purchasing power of your money, so every dollar you have buys less.
Gradual, small inflation increases are usually considered normal and can actually encourage healthy economic growth. However, high inflation that causes dramatic price increases can harm consumers and the economy — especially if wages don't increase enough to keep pace with rising prices. In some rare cases, extremely high inflation can take place — with prices for goods or services increasing by more than 50% per month. This is called hyperinflation and can be disastrous for any economy.
The opposite of inflation is deflation, a condition in which prices fall. Deflation can also be harmful for an economy, leading consumers to spend less as they wait for prices to drop even lower.
What Causes Inflation?
The market forces of supply and demand are the main causes of inflation. When the supply of a product or service can't meet the demand for that product or service, companies often raise their prices. In some cases, these price boosts can help them hire additional workers to produce the in-demand product.
In addition, companies may raise prices on items or services if the costs for labor or raw materials rise. By increasing prices, businesses can pass some of their rising costs to consumers.
How Does Inflation Affect Consumers and the Economy?
Inflation can have several negative effects on consumers:
- Diminished purchasing power: Inflation erodes consumers' purchasing power (the number of goods or services the same amount of money can buy). For example, if a candy bar's price increases from $1 to $3, one dollar loses value because it is now worth only one-third of a candy bar rather than a whole bar.
- Rising interest rates: To keep rampant inflation in check, central banks such as the U.S. Federal Reserve make changes to their country's monetary policy. This usually involves increasing minimum interest rates. The goal of increasing interest rates is to encourage consumers to spend less. After all, credit card debt, home loan debt, etc., becomes more expensive when rates rise.
- Recession: In some cases, too-high inflation can cause consumers to spend too little, triggering negative economic growth and recession. One of the main effects of a recession is an increase in the unemployment rate as workers lose their jobs. Recessions can last for months or even years.
How to Prepare for Inflation
Here are some steps you can take to prepare for growing inflation and make the most of your dollars when prices rise.
Build an Emergency Fund
When money is tight, an unplanned emergency such as a car repair or medical emergency can cause intense financial stress. Having an emergency fund in place can keep you from going into debt or overdrawing your checking account to cover these expenses.
To start an emergency fund, consider opening a savings account that pays interest on deposits. High-yield savings accounts can give your emergency fund an extra boost, too.
Although there's no one-size-fits-all answer regarding how much money to save in an emergency fund, a good rule of thumb is to aim for several months' worth of expenses such as rent, mortgage, utility bills, food, and transportation.
Saving this much money won't happen overnight. But by building a regular savings habit now, you can be in a much safer position if an emergency strikes.
Create (and Stick to) a Budget
Having control over your spending can help you avoid some of the negative effects of inflation. When you know where your money is going and how much you're spending, you're better poised to make smart decisions when prices rise. You can do this by creating (and sticking to) a budget.
There are many options and strategies for budgeting, including the envelope system (in which you earmark money for certain spending categories) and the 50/30/20 budget, which involves spending 50% of your income on needs, 30% on wants, and 20% on savings.
However, budgeting can be as simple as tracking your expenses regularly using your bank's mobile app.
By keeping tabs on your income and expenditures, you'll have a good idea which expenses can be cut back when prices rise.
Find Ways to Save on Essential Purchases
Despite rising inflation, you still need to eat, put gas in your fuel tank, and dress yourself. However, when you're feeling a financial crunch, there are ways to spend less on these essential items.
- Switch stores: When prices rise, consider shopping at less expensive stores, such as discount supermarkets, warehouse stores, thrift shops, etc.
- Buy house brands: House brands, sometimes called "generic brands" or "house labels," usually cost less than name brands. Typically, the quality of the food or merchandise is just as good as the more expensive labels.
- Buy in bulk: Buying food and toiletries in bulk can often result in savings. However, be sure you're not "overbuying" products that you don't use.
- Clip coupons: For decades, shoppers have saved money at retail and grocery stores with coupons. Today, it's easier than ever to find coupons on the internet that will let you save money both online and at brick-and-mortar businesses.
- Sign up for free clubs and loyalty programs: You can receive special offers and discounts by signing up for clubs and loyalty programs with your favorite retailers. Some loyalty programs even allow you to save money on gasoline.
Reconsider the Nonessentials
Spending on nonessential items and services can add up over time. Here are some areas where you may be able to trim your spending.
- Cancel subscriptions you don't use: These days, online subscriptions have become incredibly popular. But do you need multiple streaming services? Look at what subscriptions you use and cancel the ones you don't.
- Entertain at home: Instead of spending a ton of money on a pricey night out with friends, consider inviting them to your home for a game night, potluck dinner, or other fun.
- Find low-cost or free activities: From public parks to community festivals, plenty is happening that is free or low-cost. Check out events posted in local social media groups or websites. Public libraries can also be a great resource for free activities.
Financial Products to Consider During High Inflation
As mentioned above, during periods of high inflation, central banks often raise interest rates to discourage consumers from spending with credit cards and other debt products.
However, these conditions could also work in your favor. That's because the amount of interest your bank pays on savings products may increase, as well.
Here are some banking products you may want to consider when inflation is on the rise:
- High-yield savings accounts: While all interest-paying savings accounts can help you earn more money on your deposits, high-yield accounts put your money to work. In fact, high-yield savings accounts may pay as much as 10 times more interest than what you can earn with a traditional savings account.[1]
- Money market accounts: Money market accounts also typically offer higher interest rates than traditional savings accounts. However, unlike most savings accounts, money market accounts sometimes allow an unlimited number of withdrawals per month. This makes money market accounts worth considering if frequent access to your cash is needed. However, money market accounts may also have strict requirements for minimum deposits.
- Certificates of deposit: Certificates of deposit (CDs) are savings tools that require you to leave your money deposited for a specific period of time. However, CDs typically offer generous interest rates. When considering a CD, it pays to fully understand your bank's terms and early withdrawal penalties.
The Bottom Line
Inflation can put a serious dent in your wallet if you're not prepared. But rising prices don't have to spell disaster.
Fortunately, there are many steps you can take to shore up your finances against inflation. As a bonus, many of the tips mentioned here can be financially beneficial no matter what's happening in the economy.
