Protect Your Money by Managing Your Personal Inflation Risk

What is inflation?

Inflation refers to an increase in the average price level in the economy. One way economists measure inflation is by tracking the price of an “average basket” of goods in the economy. The most common inflation index is the Consumer Price Index.

It’s important to remember that inflation is an average. Some goods, notably electronics, decrease in price even when there is inflation.

What is the risk?

A dollar just doesn’t go as far any more

Inflation means a dollar buys fewer goods than before.

This is not necessary a problem since inflation can affect salaries and expenditures at the same time. If you were given a 5% raise and inflation was 5%, then you could still buy the same goods on average. Employers typically account for inflation when giving raises.

The things most vulnerable to inflation are stated in fixed dollar amounts. These don’t get adjusted and inflation erodes their purchasing power. Some examples are:

• Cash of all kinds
  • paper money, checking accounts, savings accounts
• Fixed income
  • bonds, social security, pensions—though adjustments like cost-of-living-allowances may reduce the pain
• Money you lend out
  • $1,000 your friend returns to you ten years later

There is one more cost to inflation. Because prices rise, companies have to update their listings in brochures, menus, and other materials. These costs are aptly named “menu costs.”

Are there any good aspects?

In theory, inflation helps borrowers with fixed interest or fixed dollar amount loans. If you have to repay a fixed amount of money, then inflation reduces the real value of the debt.

This benefit is not always realized because financial institutions compensate. As pointed out on Advanced Personal Finance, first time home buyers can get priced out of the market with absurdly high interest rates.

How can I manage inflation risk?

There are three typical ways to deal with inflation risk.

• Spend money now

It’s not often we American money writers can encourage spending, but this is one such case. Money you spend now avoids inflation risk.

Unfortunately, this strategy encounters several other risks if you overspend. But it is a time when spending money now is better, and it serves as a reminder to super-savers that money later is not always better than money now.

• Buy investments with higher returns (like stocks)

I try to warn people that FDIC-guaranteed deposits are not risk-free. Money kept in cash or low-interest checking and savings accounts is virtually guaranteed to lose purchasing power.

An example: money in a no-interest checking account almost loses a whopping 25 percent of its purchasing power over 10 years, assuming a moderate 3 percent inflation rate. Even high interest rate savings accounts like ING Direct are unlikely to beat inflation when taxes are considered.

To increase purchasing power and outperform inflation, it’s necessary to invest in higher return options, like stocks. While these investments have own risks (all the money can be lost), there ways to manage them through some long-term strategies like having a well-diversified portfolio. More on that in another article.

To summarize: inflation risk makes it necessary to find higher return investments like stocks.

• Consider Treasury Inflation-Protected Securities (“TIPS”)

It is possible to get a guarantee on principal and keep up with inflation. The U.S. government has created bonds with returns indexed to inflation. Some worry that TIPS have had too low rates, even after considering the inflation adjustment.

But some advisers, like Scott Burns at AssetBuilder, suggest TIPS can be an important part of a well-balanced portfolio. I’ve read the inflation-adjustment raises some important tax considerations, so do your work before investing.

Side Topic: Why can’t the government make inflation zero?

I want to preempt an often asked question: why does inflation exist at all?

This is a controversial question, so I’ll just stick to the basics from my economics training. There are two main reasons why “some” inflation is okay.

The first reason is that inflation is better than deflation, which means prices would be scaled back. Why is this bad? Deflation means that all debtors have larger obligations. This would increase the rates of defaults and could lead to a big credit crisis. Companies go bankrupt, workers get laid off, and loans are hard to come by. This is what happened during the Great Depression, America’s worst economic contraction.

The second reason is that inflation can occur when pursuing other desirable policies, like having a high employment rate. There are two processes called cost-push inflation and demand-pull inflation that explain the phenomenon.

Ultimately, I don’t worry too much about these policy matters as I have little impact on inflation. I focus on being prepared practically, which means choosing good investments.

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