What is Inflation — and what does it mean to you?

You’ve heard about inflation, and lately you may have heard the word used a lot in the news. That makes now a particularly good time to brush up on your knowledge about inflation and what it could mean to your finances.

What is inflation?

Inflation is what we call it when prices rise for multiple items — like groceries, gas, movie tickets and airfare — and your money doesn’t go as far as it used to. “Inflation deteriorates one’s purchasing power as the cost of goods and services becomes more expensive,” explains Michael Cody, C.F.A., director of fixed income trading, Commerce Trust, a division of Commerce Bank. “Inflation affects a person’s cost of living, their budget and interest rates,” he adds.

What causes inflation?

The two primary causes of inflation are when demand for products exceeds supply or when production costs rise. Both lead to an increase in prices. An increase in government spending can also lead to inflation. The Federal Reserve Board works to manage inflation, generally aiming to keep it around 2% to maintain a healthy economy.¹

What’s happening with inflation right now?

Inflation recently reached 5% — its highest point since 2008. That’s why you may have seen prices for some of your favorite products go up. You may also have noticed companies charging the same price for a product that now comes in a smaller package, so you don’t get as much. This is a phenomenon economists call “shrinkflation,” and it’s a way for companies to avoid losing profits without raising the cost of their product. Like inflation, shrinkflation reduces your purchasing power because you get less for your money.

The Fed and other economic experts attribute the current rise in prices and inflation to multiple factors, particularly rebalancing supply and demand post-pandemic. As demand for spending on goods and services has increased, many supplies have remained limited. “The supply challenges we’re facing right now are a cause for rising prices,” explains Cody. “For example, car manufacturers can’t get the parts they need fast enough to meet the current demand.”

Other factors contributing to rising prices include the economy reopening as lockdown restrictions are lifted, stimulus money being spent and a general rebalancing of below-average inflation over the past few years.

What’s the impact of inflation on the economy?

The Fed expects the recent higher inflation to be temporary², and historical data shows that what’s happening now is normal and not unexpected. In fact, moderate inflation can signal a healthy, growing economy. In a strong economy, unemployment rates are lower and wages usually rise, which benefits everyone.

If inflation continues for too long, however, the Fed may decide to increase interest rates to slow down spending. That decreases demand for goods and services, which can lead to lower prices and send inflation back down. “If the Fed has to take action to control inflation, borrowing costs for things like auto loans and credit cards increase when interest rates rise,” explains Cody.

How to protect your money during times of higher inflation

In a rising inflation environment, you may want to consider taking steps like these to protect your finances.

• Lock in a lower interest rate on loans, like your mortgage or your car. If you have an adjustable-rate mortgage (ARM), consider refinancing to a fixed interest rate loan before interest rates rise.

• Pay down credit card debt before variable interest rates potentially rise.

• Talk to your financial advisor to ensure you have the right mix of investments. “For savings, having exposure to equities can help you counter the negative effects of inflation, especially when it involves your retirement savings” explains Cody.

• Continue to build your emergency fund and savings for other goals.

Cody agrees with the Fed and economic experts who see the recent increase in prices and demand for goods as transitory and short-term. “This current inflationary period is different because we’re coming out of something we’ve never experienced before,” explains Cody. “People stopped spending for months during COVID-19, and now they’re ready to spend. Eventually, though, the spending will slow, and inflation will slow,” he adds.

Understanding what inflation is and what it means for your money can help you make smart financial decisions now and plan for future goals. To learn more about how inflation may impact your finances and the financial solutions you choose, contact us link opens to a Commerce contact page.

1 “Why does the Federal Reserve aim for inflation of 2 percent over the long run?” Board of Governors of The Federal Reserve, updated August 27, 2020, https://www.federalreserve.gov/faqs/economy_14400.htm

2 “Fed’s Powell Says High Inflation Temporary, Will Wane,” The Washington Post, posted June 22, 2021, https://www.washingtonpost.com/business/feds-powell-says-high-inflation-temporary-will-abate/2021/06/22/5cead218-d38a-11eb-b39f-05a2d776b1f4_story.html

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