Frequently, we come across the question, “If the current annual inflation rate is 4.9 percent, why do my expenses seem to have increased by 10 percent compared to last year?” This question highlights the significance of comprehending how inflation is calculated and its potential impact on your money.
What is Inflation?
Inflation is the upward movement of average prices. The Consumer Price Index (CPI), released monthly by the Bureau of Labor Statistics, tracks these fluctuations using expenditure data from various categories such as food, housing, transportation, medical care, and more.
How Applicable Is the CPI?
The CPI is a commonly used indicator of inflation, but it has strengths and limitations. For example, it is valuable for monitoring inflation trends and price movements, yet it may not accurately reflect an individual’s inflation rate. This is because of varying spending patterns and consumption categories for each person.
Are Investments Affected by Inflation?
Yes, as inflation rises and falls, three notable effects are observed.
- Inflation reduces the real rate of return on investments. So, if an investment earned 6 percent for a 12-month period and inflation averaged 1.5 percent over that time, the investment’s real rate of return would have been 4.5 percent.
- Inflation puts purchasing power at risk. When prices rise, the same fixed amount of money purchases fewer goods.
- Inflation can influence the actions of the Federal Reserve. To combat inflation, the Fed has various methods to reduce the money supply. This reduction in circulation can potentially lead to decreased spending, lower prices, and consequently, lower inflation.
High inflation may prompt drastic changes, especially when you see the inflation rate not aligning with your expenses. Inflation impacts everyone differently, so take the time to monitor how it affects you and your money.
Information in this material is for general information only and not intended as investment, tax or legal advice. Please consult the appropriate professionals for specific information regarding your individual situation prior to making any financial decision.
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