How Inflation Can Impact Your Savings Strategy

May 3, 2021

What is inflation?

Inflation is defined as the decline of the purchasing power of a given currency over time. This phenomenon is materialized through increased prices across a wide range of goods over an extended period of time. Inflation is essentially a tax that everyone is forced to pay whether they know it or not. People who understand how to beat inflation can supercharge their savings strategy and those who don’t might find themselves coming up short of their savings goals.

For example, have you ever caught yourself wondering how the price for a gallon of gas has shot through the roof? Or a week’s worth of groceries can cost more than usual? Or how rent can easily cost over $2,000 in some markets? For the most part, the steady increase in the prices of these goods is caused by inflation. If you are not careful, inflation can shrink your savings account of its value.

How does it happen?

In the U.S., inflation occurs when the central bank of the United States (The Federal Reserve) prints more money and adds it to the U.S. money supply. This can be visualized on a smaller scale by imagining a game of monopoly.

If all players start with $500 then the most that any player can bid to buy a property is $500. This means that the maximum value of a given property is $500. However, if you double the starting amount to $1,000 then players are able to bid the price of that same property up to $1,000, essentially doubling the value of the property. Our question is this...does the value of the property actually change? Or do people just have more money to spend?

This happens on a much larger scale to practically all products when the Federal Reserve prints more money.

The main benefit

The Federal Reserve doesn’t print money for no reason. Usually, it’s done to encourage people to spend more money. If people have money in their pocket, they are likely to go out shopping, spend more at stores, go on vacation, etc. Spending is almost always good for the economy because:

  1. It increases business profits
  2. Allows businesses to expand and hire more people
  3. Provide people with financial assistance

Essentially, printing more money encourages spending and keeps the economic wheel spinning.

The main drawback

Printing excess money also has a very severe drawback in that it decreases purchasing power. As we saw with the Monopoly example, this will mean higher prices for goods down the road. This is definitely something that you need to take into account when saving money.

Investments worth considering

If you are trying to save for a long-term goal, then it’s important to take inflation into consideration. The average rate of inflation is generally between 2-3%, although many people think that it is actually much higher than this. This means that the same good that costs you $100 in 2020 is likely to cost over $200 by 2050.

In order to avoid letting inflation eat away at your savings, you can look into investing your money in a place where it will grow at a rate faster than the rate of inflation. Like most investments, there are risks associated. It’s important to understand the risks and rewards of each strategy. Here are a few options you can consider:

  • High-yield savings accounts - Offered by most online banks.
  • Investments accounts - Stocks, bonds, real estate
  • Retirement accounts - 401(k), Individual Retirement Accounts, etc

Inflation’s impact gets bigger and bigger over time. We might not feel the effects of inflation right away but you can consider ways to protect yourself against its more negative effects.