As we enter the first quarter of 2022, it is apparent that inflation is here and continuing to increase. The latest Consumer Price Index report on inflation details how the all items index rose 7% over the course of 2021, and that trend is likely to stay the course throughout this year, too. While inflation has a serious impact on our economy, many different actions can be taken to protect your finances when the economy is facing inflation.
However, before we can jump into protecting our financial outcomes, we need to make sure we understand just how inflation and rising interest rates impact us as consumers and wealth planners. Within this two-part series, we will explain how your finances may be impacted, as well as how you can implement protection now.
Inflation is commonly spoken about in economics, but what does it actually mean? To put it as simply as possible, inflation is when more dollars chase fewer available goods, causing prices to surge and your dollar not to go as far. So, regarding the 7% increase we experienced in 2021, this means that the prices you were used to paying for your goods and services have likely increased that percent or more. Inflation also impacts interest rates, as these two parts of the economy have an inverse relationship with each other. Meaning when one goes up, the other goes down.
In response to COVID-19, the government stimulated the economy with more cash through multiple stimulus payments throughout 2020 and 2021. Therefore, our economy is experiencing a surge in cash flow with no increase in available goods. Thus, inflation is an inevitable result of that equation. Because of the current inflation we already experience, many economists predict higher interest rates in 2022 to combat the inflation surge (remember–interest rates and inflation have an inverse relationship).
Stagflation refers to an economy experiencing a simultaneous increase in inflation and stagnation of economic output. Stagflation was first recognized during the 1970s when many developed economies experienced rapid inflation and high unemployment as the result of an oil shock.
There’s a bit of a debate on whether the increased inflation from 2021 will result in a stagnant economy for 2022, but it is possible that stagflation could become our reality. Many experts point to concerns around labor shortages due to the pandemic and how that will cause the economy to stagnate as companies will be required to pay higher wages. This would continue to cause inflation to increase, meaning our economy may face stagflation as a result. However, it will be a wait-and-see game for now.
With inflation increasing and interest rates likely rising, there are a few things we can do as wealth planners to prepare for this year:
The increased inflation will likely erode the buying power of your earnings, leading to a potential increase in your cost of living. This means your earnings will not stretch as far as it has before, assuming your earnings have not increased significantly. For example, if you made $130,000 in 2011, your wages would need to have risen to $156,000 in 2021 just to break even due to the increased inflation. This leaves less room for investments and overall buying power since you’re essentially making less.
Increased inflation will cause everything along the supply chain (from materials, labor, and even transportation costs) to increase in price. Those increases, though perhaps not immediately, will be borne by consumers. Just as your buying power erodes and your cost-of-living increases, so will the prices of everything around you. Expect to pay more for real estate, essentials, and entertainment as the supply chain prices attempt to keep up.
Because interest rates will likely continue to rise to combat the increased inflation, economic growth will be forced to slow down. Just as consumers bore the impact of inflation, consumers will also be the ones who bear the brunt of the effects of slower economic growth. When the economy experiences slower growth, we can expect to see fewer jobs available, fewer consumers purchasing, increased government assistance, and a possible increase in unemployment.
Bottom Line: With increasing inflation and rising interest rates, we can expect our buying power to erode, prices to increase, and economic growth to slow. What can you do to protect your finances? Check out part two of this series and be sure to give us a call for more insight on your personal financial goals.