Inflation: What exactly is it?
Inflation: What It Is, Why It Happens, and What You Can Do About It
Inflation. You can’t look at the news without seeing the word these days. And with rates at a 40-year high of 8.6 percent, it’s no wonder.
In 2022, prices saw the largest single-year increase since 1979, with food and energy hitting especially hard.
When people encounter the word “inflation,” they might not be entirely clear on what it means. There’s just a sense that in general, it’s not good — and that you can’t get that loaf of bread for 20 cents like your grandparents did.
But what exactly is inflation? What causes it to spike? And is it always a bad thing?
What is Inflation?
Inflation is simply the increase in the average price of goods and services.
In short, a dollar won’t go as far as it did before. As prices go up, the value of currency goes down. They have what economists call an “inverse relationship.” One goes up, the other comes down — like a seesaw.
When the price of groceries goes up 15%, that line item in your budget buys less.
When housing prices spike, the money you’ve saved for a down payment doesn’t stretch as far.
When gas prices soar, it doesn’t just affect your commute — it hits every sector reliant on transportation.
The Economic Cycle
This often happens when everything is going well — business is booming, unemployment is low, pay is high.
When people have more disposable income, demand for goods and services rises, and so do prices.
But if prices rise too much, people buy less. Demand decreases, production slows, companies need fewer employees, and the economy enters a downturn. This is a natural part of the economic cycle.
When Inflation Spikes
Inflation is a normal part of the economy, averaging a long-term rate of 3.2% per year.
But sometimes inflation spins out of control.
Often the Federal Reserve steps in by raising interest rates. While effective at curbing inflation, this can sometimes overcorrect and trigger a recession: unemployment rises, wages stagnate, production slows.
When that happens, companies lay off workers and raise prices further, compounding the problem.
Eventually, inflation slows down. But in the meantime, your money and investments need to work even harder to keep up.
What Drives Inflation?
It’s often about supply and demand.
When demand outpaces the ability to supply goods and services, prices rise.
Some sectors — especially energy — have such an outsized impact that a surge there can set off a chain reaction across the economy.
War can disrupt oil supplies.
Drought can drive up grain prices.
Pandemics can cause shortages across multiple sectors.
The Covid-19 pandemic in 2020 caused production to grind to a halt. When demand surged back in 2021, supply couldn't keep up, and inflation took off like a rocket.
What Can You Do?
Personal Finance
When inflation is high, you have three options:
Spend less
Use your savings
Go into debt (only if absolutely necessary)
In order of preference, the best thing you can do is tighten your budget.
If your purchasing power has dropped by 10%, your spending should decrease accordingly unless your income has increased to match inflation.
Using savings should be a last resort.
Going into debt? Only if you must.
Investments
During times of high inflation, commodities typically perform well.
Remember: when input prices rise (like oil, grain, or metals), investing in these sectors can help offset inflationary losses elsewhere.
Gold?
Popular wisdom says it’s a hedge against inflation — but at NEST, we disagree.
Gold has a low correlation to inflation.
Sometimes gold prices rise during inflationary periods — sometimes they don’t.
Correlation matters, and gold just isn’t consistent enough to count on.
(Source: MacroMicro 2022)
Ready to Get Your Finances Inflation-Proof?
If you have more questions about inflation, or want to make sure your personal finances and investments are ready to thrive in any economic climate, schedule a no-obligation call with us.
At NEST Financial, we’ve been navigating economic ups and downs for nearly 30 years, and we’d love to help you do the same.
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DISCLAIMER:
We are legally obligated to remind you that the information and opinions shared in this article are for educational purposes only and are not financial planning or investment advice. For guidance about your unique goals, drop us a line at info@nestfinancial.net.