When you hear about inflation, you probably think of paying higher prices for items at the grocery store. That's a good place to start, but because inflation affects your purchasing power, it's also important to consider how it affects other financial decisions and parts of in your life.
The inflation rate is a measure of how much prices are changing. Generally, they increase. When prices decrease enough that the inflation rate drops below 0%, that's called deflation.
There are three primary measures of inflation in the U.S. The consumer price index (CPI) and personal consumption expenditures (PCE) price index both track a basket of goods and services, though they differ in ways including the weighting for various expenses, who is surveyed (households versus businesses), and the scope of what's covered by each index. Then there's the producer price index (PPI), which measures the average change in prices that companies set for the products they sell.
The current pace of inflation, based on these three measures, ranges from 1.3% to 2.3%. One of the Federal Reserve's aims is keeping inflation in check, and the PCE is its preferred measure. This inflation rate, currently at 1.6%, remains below below the central bank's long-term target of 2%.
While you may notice prices going up or down for things that you buy regularly, inflation has a broader impact on your bottom line. Here are five ways it can affect you:
Let's start with the most obvious: The rate of inflation affects how much you pay for goods and services. But just because you notice that the price of something you pay for regularly has gone up, that doesn't mean there's broader inflation in the economy.
That's because the government is tasked with measuring a basket of thousands of goods and services each month and then calculating the overall average change in prices. So while the cost of health care, for example, has been steadily rising in recent years, gas prices often fluctuate month-to-month.
The rate of inflation also varies across the country, and those differences are most directly affected by the cost of housing in different areas.
Video by Courtney Stith
Because the inflation rate (specifically the CPI) is meant to measure the cost of living for a typical consumer, companies also use it as a benchmark for compensation increases.
Employers may use the rate of inflation as a starting place for determining if they'll increase workers' salaries each year, and by how much. This is what's known as a cost-of-living adjustment (COLA). In addition, if you're moving to another state, you should be sure to take into account the cost of living in that region, and use this when negotiating your salary.
In addition, the Social Security Administration uses CPI to calculate whether annual increases to Social Security benefits are warranted. For 2020, retirees will get a 1.6% bump in their monthly checks.
Chances are that inflation is eating away at some of the money you're able to put away. That's because the average interest rate on a traditional savings account — currently 0.27%, according to Deposit Accounts — is far lower than the rate of inflation, at 1.6%.
Even taking into account compound interest, in which you earn money on the money you've deposited and interest that's already accrued, saving money in a traditional savings account all but ensures that money has less purchasing power in the future. Worse yet? Keeping that money under a proverbial mattress where it doesn't earn any interest at all.
However, it's possible to keep pace, or even slightly outpace, the rate of inflation by opening a high-yield savings account. While some banks require a higher minimum balance with these types of accounts, the national average currently is 1.85%.
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The most reliable way to grow your money at a faster clip than the rate of inflation is by investing in the stock and bond markets.
It can be difficult to get over the fear of losing money in the short term, but investing remains the best way to grow your wealth, according to experts. And the most common regret for investors is not getting started earlier.
While there is uncertainty associated with investing your money in the stock market, there are ways to manage those risks. And giving yourself decades to benefit from the market's proven long-term performance is one of the best ways to do so.
For example, the S&P 500 has delivered average annual returns of about 10%, far outpacing the rate of inflation. Add you'll also grow your money even faster with investing thanks to compound interest, which Albert Einstein reportedly called "the eighth wonder of the world."
It can be helpful to consider the missed opportunities of not investing — like seeing how a hypothetical $500 investment would have fared in the past decade — or to visualize how much your money could grow over time by playing around with Grow's retirement calculator.
The Federal Reserve is tasked with helping to maintain a well-functioning economy by keeping an eye on three key goals: maximizing employment, keeping prices stable, and moderating long-term interest rates. Keeping prices stable is just another way of thinking about inflation.
Central bankers want to strike a balance between some inflation, but not too much. Their long-term target for the inflation rate is 2% and, to achieve that, when necessary, the Fed will adjust interest rates.
Video by Courtney Stith
When economic growth is strong, the Fed raises interest rates to keep inflation in check. Policymakers cut interest rates when economic growth is slowing in an effort to stimulate activity by making it cheaper for consumers and businesses to borrow money.
While the inflation rate isn't one of the primary indicators that economists track for signs of a possible recession, it is useful for gauging the health of the economy. In turn, what central bankers do with interest rates to keep inflation in check can have a big impact both on the markets and the rate you'll pay to borrow money or earn to save it.
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