Understanding Inflation

Many people forget a very important factor when planning their retirement goals and choosing their investments. Inflation is robbing you right now. Be afraid! Well, actually, this article will remove the mystery surrounding inflation and so you don’t have to be afraid any longer!

What is inflation? It is the steady drop in the purchasing power of your money over time. Do you remember talking to your parents about how they could buy so much for just a nickel back when they were kids? Or how your Mom’s first car only cost her $2000? Even in our generation we can remember when gas prices were lower, or when milk was cheaper. This means that if your grandparents had $1000 fifty years ago they could buy a whole lot more than we can today with the same amount. Money loses it’s power over time. So you need more money tomorrow to buy the same thing as you would need to buy it today. If you can live comfortably on $60,000 today, then when you retire in 20 years, you’ll need to adjust that amount by the inflation rate.

What Problems Does Inflation Cause?

Inflation means that you have to think in terms of inflated dollars when you plan for your future. It also means that you have to make sure your money is earning at least equal to the rate of inflation, just to break even. So, if your money is in a mattress or in a chequing account earning no interest, then you are actually losing money. Inflation is eating away at it. On average, inflation runs at about 2 – 4 %. So if you aren’t earning at least this (after taxes) on your investments, then you’re losing money. This makes savings bonds, certificates of deposit and savings accounts – investments usually seen as low or now risk – into risky investments. You risk losing money if inflation rises above your after-tax interest rate earned. Inflation is also dangerous because many people fail to account for it- so they don’t compensate for it in their planning and investing. Silent but deadly.

Getting Solid Information

The best way to plan for inflation is to know what it’s at currently and what the historical values are. The Canadian and American federal banks have gotten better and better at managing inflation at reasonable levels. You can view the current and historical inflation (CPI) information at these links:

Bank of Canada
USA Bureau of Labor

As I’m writing this article, inflation is at a pretty low level. It’s also a good measure of the health of the economy.

Many factors influence inflation, but one of the big factors driving it is the fact that companies periodically raise the prices of their products to try to make more profits. And workers typically expect or demand pay increases. These two things tend to reinforce each other. If inflation increases out of control, it can have disastrous effects on the economy. Fortunately here in Canada and USA we have experts whose job it is to keep an eye on inflation and to tweak things to hopefully keep it in check.

You’ll often hear in the news something like that inflation is up so the central bank is going to raise interest rates. What does this mean? Well, when interest rates go up, people tend to save more (because savings earn more interest) and spend less (because loans cost more). Raising interest rates will slow the economy down. And a slow down in consumer spending often helps to slow down inflation. And the opposite is true. If the economy is too slow, the central banks will lower interest rates to encourage more spending (like buying houses because mortgages will be cheaper).

What Should We Do About It?

Always make sure that your investments and savings are earning more interest than the rate of inflation. At the very least, an online savings account can earn 4-5% interest. Your income should also increase accordingly. If you get no raise at all in a year, it’s actually like getting a pay cut.

Also be careful to factor inflation into your long term savings, income, or retirement planning. This will help you have more accurate numbers. Knowing is half the battle, and now you can take steps to keep inflation from sneaking up on you.