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In this article, I am going to explain in simple terms what inflation is, what causes it, how it’s controlled, and it’s implications on your financial planning.
Disclaimer: This article is educational and not advice. Please seek the council of a licensed professional before making any changes to your finances, to ensure they make sense for your unique situation. I am happy to help, or you can visit www.brokercheck.org to find an unbiased list of professionals.
What is inflation?
Put simply, inflation is a law of finance that the cost of everything will go up, or “inflate”, over time. Much like gravity, which is a law of nature, it can be altered, but it will never go away. On average, the cost of everything will always go up.
The rate of inflation is most commonly measured by tracking the cost of the “essentials” of daily living; food, clothing, shelter, transportation, healthcare, communication, education, and recreation.
This rate is most commonly referenced via the “CPI” or consumer price index, which is published by the US Bureau of Labor Statistics (in the USA), and the “rate of inflation” is the percentage increase of the CPI over where it was the previous year on the same date.
What causes inflation
Human greed causes inflation, because everyone wants to make more money so they can live a better life, and raise their prices (goods, services, time, etc). This motivation causes a chain reaction that results in the cost of everything increasing.
Explaining everything that causes and contributes to inflation would require a college textbook, so in this article we’re just going to focus on a simple example that will help you understand the concept. From there, you can extrapolate the process and apply it to just about anything. It’s called the “Big Mac Index”.
When you stop to think about it, a lot of products, services, and labor go into putting a Big Mac in the hands of a consumer… All the ingredients have to be farmed, processed, packaged, transported, prepared, and marketed to be sold and consumed. There are a LOT of people and resources involved in that process, so the cost of a Big Mac is more or less the manifestation of the cost of everything it takes to make and sell one. Therefore, when the price of a Big Mac increases, that’s a real life example of inflation.
Inflation is a never ending, self-feeding cycle caused by people having to raise their prices, because someone else raised their prices, and so on. McDonalds charges more for the Big Mac because the cost of meat went up, and the cost of meat went up because the cost of feed went up, and the cost of feed went up because the cost of labor went up, and the cost of labor went up because people need more money to buy their Big Macs and demanded raises…
How inflation is kept under control
While inflation is a healthy thing in moderation (I mean, everyone wants a raise each year, right?), if left unchecked it can run rampant and wreak havoc on society. With every additional percent over 2%, making ends meet becomes increasingly difficult for the lower and middle class, which constitute the vast majority of the population. They also tend to be pretty bad at managing their money and live roughly paycheck to paycheck. We are more or less calibrated to the cost of living going up each year by a little, but if it goes up by a lot, everyone panics. People start cutting back on unnecessary expenses like travel, clothes, eating out, etc., and those who ride the edge start defaulting on their loans. All of this causes companies to start laying people off, which causes more of the same problems. This is what causes an economic collapse, recession, or depression.
Using the Big Mac scenario described above, you begin to understand why things like the minimum wage, fuel prices, and interest rates make a big difference in how quickly costs inflate and have far reaching effects on the economy.
That’s why the news talks about it so much, and the stock market reacts so strongly to, any announcement from the government regarding changes to these “levers” controlling the economy.
Let’s take a look at how each of these items has an impact on the economy and inflation;
The minimum wage
Generally speaking, human resources is the most expensive category on a company’s profit & loss statement, and all salaries are tied to the minimum wage. This is simply because when the lowest guy on the ladder gets a raise (minimum wage increase), everyone else wants a raise as well to keep things fair.
Therefore, the government controls the single largest production cost in the economy, the minimum wage, which directly affects prices, and thus inflation.
Fuel prices
While the government does not directly control fuel prices, they do set policy and can change these policies at will to be either pro-oil or anti-oil (“green”), such as; the ease of producing oil through zoning and permits, the taxes imposed on imported oil, and taxes on the sale of oil.
Since it takes enormous amounts of fuel to produce most goods, and then deliver them to consumers, even a small change in fuel prices has a big impact on the economy and inflation.
Interest rates
Most of the world is made possible by “leverage”, or credit. For example, many businesses have lines of credit for projects to equalize cashflow, the vast majority of houses are bought with a mortgage, and most households in the US carry thousands of dollars of credit card and consumer debt. Well, the interest rate set by the bank on all of these items is based on the federal funds rate, which is essentially the rate banks charge each other (it’s pretty complicated, but that’s basically the idea), and the amount of money in the system is largely controlled by the reserve ratio which dictates how much money banks can lend out as a multiple of their deposits (also very complicated).
Therefore, if the Government raises rates, it makes borrowing more expensive and less appealing, and vice versa, reducing or increasing spending, and thus sales, and thus profits. Correspondingly, by changing the reserve ratio, they can control how much money is available to be spent.
How inflation affects you
Inflation affects you in a number of ways, both immediately, and long term. Therefore, it’s important to factor it in when doing budgeting and planning. While it varies from year to year, you can expect inflation to be about 3% per year, 4% if you want to be on the safe side.
The primary way inflation affects you is in the current cost of living. It’s always a good idea to save 10-15% of your income in some way or another, but the often unnoticed benefit of doing this is that it gives you a buffer for inflation.
See, inflation is the SBD killer of finance, because you don’t feel it until it’s too late. Kind of like the old “how to cook a frog” analogy. Therefore, having a 10-15% buffer gives you room inside your budget for when unexpected inflation eats into it. It buys you time so you can adapt your spending or find ways to make more money.
The other way inflation affects you is in retirement planning, because for many, retirement is years if not decades in the future. So when doing your retirement projections, you need to inflate expenses and savings to account for the rising costs of living, both leading up to and throughout your retirement to life expectancy. I wrote a comprehensive article on how to do that here: Retirement Planning Guide
Conclusion
Inflation is a complicated topic that is both fascinating and sobering. One that you cannot ignore and must plan for to ensure you are able to maintain your lifestyle both now, and in the future.
And next time you go to McDonalds and order a Big Mac, look over at someone, point at your sandwich and exclaim “that’s inflation right there!!”.
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