Rising prices due to inflation can put a strain on your budget and savings. When the cost of goods and services increases, your money doesn’t stretch as far. This erosion of purchasing power makes it harder to maintain your standard of living. However, by understanding how inflation works and taking proactive steps, you can mitigate its impact.
While a moderate level of inflation is normal in a growing economy, recent years have seen worrisome spikes driven by factors like supply chain disruptions and changes in monetary policy by the Federal Reserve. To combat this, it’s crucial to examine your spending habits, seek savings opportunities, and explore ways to boost your income. With smart money moves, you can insulate your wallet against rising inflation and economic uncertainty.
What is Inflation?
Inflation is a gradual loss of purchasing power, reflected in a broad rise in prices for goods and services over time. The inflation rate is calculated as the average price increase of a basket of selected goods and services over one year. High inflation means that prices are increasing quickly, while low inflation indicates that prices are increasing more slowly.
Measuring Inflation
Inflation is typically a broad measure, such as the overall increase in prices or the increase in the cost of living in a country. However, it can also be calculated more narrowly for certain goods, like food, or services, like a haircut. Whatever the context, inflation represents how much more expensive the relevant set of goods and/or services has become over a certain period, most commonly a year.
Impact on Purchasing Power
To the extent that households’ nominal income, which they receive in current money, does not increase as much as prices, they are worse off because they can afford to purchase less. In other words, their purchasing power or real— inflation-adjusted—income falls. Real income is a proxy for the standard of living. When real incomes are rising, so is the standard of living, and vice versa.
Fixed Interest Rates
Inflation can also distort purchasing power over time for recipients and payers of fixed interest rates. For example, pensioners who receive a fixed 5% yearly increase to their pension would see their purchasing power fall if inflation is higher than 5%. On the other hand, a borrower who pays a fixed-rate mortgage of 5% would benefit from 5% inflation because the real interest rate (the nominal rate minus the inflation rate) would be zero. Servicing this debt would be even easier if inflation were higher, as long as the borrower’s income keeps up with inflation. The lender’s real income, of course, suffers. To the extent that inflation is not factored into nominal interest rates, some gain and some lose purchasing power.
How Inflation Impacts Purchasing Power
Erosion of Purchasing Power
As prices rise due to inflation, the purchasing power of consumers diminishes. When households’ nominal income (the money they receive) does not increase at the same rate as inflation, they can afford to buy fewer goods and services. In other words, their real income (inflation-adjusted income) decreases, leading to a lower standard of living.
Wage Growth vs. Inflation
While higher inflation often prompts wage growth, wage increases may not outpace the inflation rate. If the inflation rate exceeds the percentage of wage growth, consumers effectively lose purchasing power, even with a raise. Real wages, which reflect wage growth relative to inflation, provide a better gauge of how much purchasing power has changed.
Savings Devaluation
Inflation can significantly erode the value of savings over time. For instance, with an inflation rate of 2%, a lump sum of savings would lose approximately half its purchasing power in 36 years (using the rule of 72). During periods of high inflation, savings accounts can lose value even more rapidly.
Fixed Income Impact
Inflation can distort purchasing power for recipients and payers of fixed interest rates. Pensioners receiving a fixed yearly increase may see their purchasing power fall if inflation exceeds that increase. Conversely, borrowers with fixed rate mortgages may benefit if their income keeps up with inflation, as the real interest rate (nominal rate minus inflation rate) effectively decreases.
Hyperinflation Consequences
In extreme cases, countries have grappled with hyperinflation, defined as an annual inflation rate of 1,000% or more. Zimbabwe, for instance, experienced one of the worst cases of hyperinflation in 2008, with an estimated annual inflation rate at one point of 500 billion percent. Such high levels of inflation can be disastrous, often requiring difficult policy measures to bring inflation back to reasonable levels.
Look for Savings
High-Yield Savings Accounts
A fundamental step in protecting your savings from the erosive effects of inflation is to ensure that your money is working for you, even while it’s sitting in a savings account. Traditional savings accounts often offer interest rates that struggle to keep up with inflation, resulting in a decline in real value. However, there’s a better option: high-yield savings accounts. These financial products are offered by online banks and credit unions and typically provide significantly higher interest rates than brick-and-mortar banks.
There are quite a few high-yield savings accounts offering interest rates that outpace inflation — and it’s currently possible to find high-yield accounts that offer 4.5% or more without excess requirements or costs. Just be sure to compare the different high-yield savings accounts before making a decision, taking into consideration factors like interest rates, fees, and ease of access to your funds.
Certificates of Deposit (CDs)
Certificates of deposit (CDs) are another option for safeguarding your savings against inflation. Unlike traditional savings accounts, CDs offer fixed interest rates for a predetermined period, which can range from a few months to several years. By locking in a CD rate that exceeds the expected inflation projection, you can effectively preserve the value of your money.
CDs offer varying terms, and right now, it’s possible to find CDs offering rates of 4.5% or higher on your money. And that includes short-term CDs. However, keep in mind that CDs come with limited liquidity; withdrawing your funds before the term is up can result in penalties. So, you should ensure that you’re comfortable with the length of the CD term and won’t need the funds during that period before putting your money in this type of account.
Bolstering Emergency Savings
1. Be cautious about over allocating to cash, but make sure your emergency savings are keeping up with rising costs.
2. However, some investors may want to keep more cash on hand in their emergency savings to account for the rising
cost of living that comes with inflation.
3. It’s generally recommended that you set aside enough to cover 3 to 6 months’ worth of essential expenses. If you haven’t taken stock of how much your day-to-day expenses are really costing you, your emergency savings may not be ready when you need it most.
Bring More Money In
Diversify Your Income Streams
Diversifying your income sources can be an effective strategy to combat inflation and maintain financial stability. One way to achieve this is by exploring side hustles or part-time jobs that align with your skills and interests. As the article mentions, “Diversifying your income to include a side hustle or part-time job can help you to keep up with rising costs. Plus, if you are faced with layoffs, you have something to fall back on.”
1. Leverage Your Expertise: Capitalize on your professional credentials or specialized knowledge by offering consulting services, teaching, or freelancing in your field. For instance, medical professionals can explore opportunities such as medical directorships, IV fluids bars, medical spas, locums positions, urgent care, professorships, research projects, consulting, concierge medicine, chart reviews, or sideline sports coverage.
2. Explore Unrelated Opportunities: If medically-oriented side hustles don’t appeal to you, consider venturing into completely different areas. Identify unmet needs or passions you can pursue, such as opening a bar specializing in Spanish vintages if you have a passion for wine, or contracting as an IT consultant for local practices if you’re skilled with computers.
3. Monetize Your Hobbies: Turn your hobbies or creative pursuits into income-generating activities. For example, if you enjoy writing or photography, you could start a blog or sell your work online through platforms like SquareSpace.
Leverage Your Accredited Investor Status
As a high-income earner, you may qualify as an accredited investor, granting you access to potentially lucrative investment opportunities typically unavailable to the general public. Consider exploring options like purchasing a timber farm, investing in rental real estate, or acquiring vacation homes, which can provide passive income streams and potential long-term appreciation.
Embrace the Gig Economy
The gig economy offers flexible opportunities to supplement your income by providing services on your own terms. Platforms like Spark Driver allow you to earn extra cash by delivering goods using your personal vehicle, choosing when and where you work.
By diversifying your income sources, leveraging your accredited investor status, and embracing the gig economy, you can create additional revenue streams to help combat the effects of inflation and achieve your financial goals.
