We’ve mentioned inflation in several earlier steps, so it’s time to have a closer look at this economical phenomenon, how it works and what effect it has on the economy and your personal finances specifically.
Inflation is an increase in the prices of goods and services over a period of time, leading to a loss of the relative value of our money. If you have $1,000, you can buy 10 items that cost $100 each today, but when the item price goes up to $110, the $1,000 will only buy you 9 items in the future. Inflation leads to us being able to buy less for the same amount of money.
The opposite of inflation is deflation, with prices dropping and therefore our money increasing in value. Although this might initially sound like a fantastic situation, a period of deflation is normally a sign of economic recession. When customers know that prices will go down with time and that their money will be worth more tomorrow than today, they hold off making new purchases or investments. Often times this is a vicious circle, as interest rates on loans drop (see further down as to why) so holding off bigger purchasing such as a house means not only that it will be cheaper if one waits a little, but also that the interest on a mortgage will be lower. The more people do this, the more prices drop further, the more interesting it becomes to wait even longer. Less money is spent, the government needs to make cuts as less taxes are coming in, more businesses struggle to survive, people lose their jobs and money is no longer flowing, meaning the economy is becoming unhealthy and in no time the economy is affected negatively tremendously. So in reality a situation of deflation is not generally a desirable one.
Effects of inflation
Generally speaking an economy experiencing small inflation levels is usually a sign of a healthy and growing economy, therefore economists normally welcome a yearly inflation rate of just under 2%. A relatively stable inflation rate means less insecurity and risk and a solidly growing economy. During times of low and healthy inflation rates, prices go up slightly each year, meaning it is more interesting to buy today than next year when that new purchase is more expensive. People are happy to spend and money flows, taxes are coming in for the government, no cuts need to be made, more jobs are created and with that more money becomes available to be spent again.
In other words, even though inflation at first sight doesn’t sound great when thinking about the value of your money, it also guarantees a continuously growing economy.
Inflation has a small positive effect on the value as debt as well, as a debt of $10,000 today is more than in 5 years time when those $10,000 are less significant due to value loss That said, if the interest rate on the debt is higher than the inflation rate – which will nearly always be the case for most loans after any interest free periods – long-term debt is definitely still worth paying off as soon as possible as you still end up losing a lot more money from just the interest you pay than the positive effects of devaluation of your money due to inflation can counter.
When inflation is too high however, you lose too much purchasing power. Due to prices increasing too much, employees will demand higher wages and companies will need to increase prices further in order to be able to pay these wage raises, leading to a downward spiral, whilst interest rates on loans further increase (see below). This all leads to insecurity meaning it becomes difficult for customers, companies and investors to feel they can make responsible decisions. Money then loses it value so quickly that people are unable to buy, leading to people hoarding, shops running out of supplies and a general shut down of an economy. Hyperinflation usually happens in politically unstable countries but can in theory, if inflation isn’t controlled well, happen anywhere.
Interest rates and inflation are closely connected. In general when interest rates increase, it becomes more expensive to borrow money, meaning people borrow less and therefore spend less money. When they spend less, prices increase less quickly in order to incentivate purchases today instead of in the future. This is why in the financial world, even though central banks don’t have an influence on prices, by increasing the interest rates, they do have an influence over inflation rates. By decreasing the interest rates during times of deflation, it becomes more attractive to borrow money, people start spending again and prices start to increase, which stimulates a low inflation rate. This is their way of stimulating the economy and keeping inflation and deflation under control.
To give you some idea of what inflation means from a practical sense, let’s look at how quickly money loses it value. With a 2% inflation rate, it takes almost 35 years for money to lose half of its buying power, meaning that $10,000 today will be worth the equivalent of $5,000 in 35 years’ time. With a 3% inflation rate it takes 24 years for money to lose its buying power by 50%. Since inflation rates of a growing economy are usually between 2 and 3%, the rule of thumb is that money normally loses half its buying power in approximately 30 years.
Step 46 – On Inflation and Interest Rates – in detail
- Pull out your current net worth and net worth targets. Readjust for inflation now, so you know what your real goals are. Interest rates change and can never be predicted, but working off a rate of 2.5% is a safe one, or if you want to be on an even safer side, you can take 3% as your base to work from.
- In order to calculate what your real targets should be by correcting for inflation, take the percentage (say 2.5%), divide it by 100 and add 1. So for 2.5% the number will be 1.025. Times this number with itself by the number of years you are looking into the future. For example say you want to look 25 years into the future, you calculate 1.02525 , so 1.025*1.025*1.025 (until you have the number 25 times).
- Now times that number with your goal to find out how much your target really should be if there is a yearly inflation rate of 2.5%.
- Say you are wanting to have a net worth of $500.000 in 25 years’ time, then you are really looking to have 1.85*$500.000 = almost $930.000 in 25 years.
- Repeat these steps for any other targets you have set yourself such as savings, pension pots, investments etc.
- If you have any monthly contributions worked out for any of your targets, i.e. setting aside $100 every month in order to achieve your savings target, bear in mind you should also increase these contributions in line with the inflation rate in order to stay on track.
Inflation rates are as said difficult to predict, with some years seeing higher and other years lower rates, so your calculations will never be 100% accurate. What is important here though is to at least have some corrections made for inflation and to keep correcting for this as you continue along your journey to financial freedom.
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