Updated on 02.26.07

Inflation: What Is It And Why Should I Care?

Trent Hamm

Inflation is one of those topics that crops up time and time again on the news, and it’s one of those topics that makes my wife’s eyes immediately glaze over. It’s not long before the channel has been turned or the newspaper page has been flipped. Yet inflation (and avoiding it) is one of those things that really makes the world go round – and repeatedly affects your wallet.

What is inflation? Inflation refers to a situation where something costs more today than it used to. For example, when my father was young, he used to buy a dozen chicken eggs for a dime, but today it easily costs a dollar. If you do the math on this, you’ll discover that it comes out to about 5% annual inflation.

How does inflation affect me? For the average person’s wallet, inflation is generally a bad thing. It means that with every passing year, your dollar (or euro or pound or currency of choice) is worth less than it used to be. When inflation is high, your dollar is getting cheaper faster; when it’s low, your dollar is still getting cheaper, but not as fast. Here are some ways that inflation affects your everyday life:

Higher prices at the grocery store When inflation is high, the prices at the store are going to go up faster.

Low interest savings accounts actually lose money If your savings account has a lower rate than the rate of inflation, your money is actually becoming less valuable over time. This is a good reason to find a high-interest savings account, so that your savings can beat inflation.

When inflation is high, interest rates on home loans, credit cards, and other big loans will go up. This will overall encourage people to spend less money, and thus sellers won’t be able to keep raising prices, so inflation will slow down. The government actually controls how this works through the federal reserve, which I talked about earlier.

How do I understand a news report about inflation? For most people, the important thing to listen for is the Consumer Price Index, or CPI. This is a number calculated by statisticians and released by the United States government on a monthly basis (many other first world nations also release a CPI monthly). The whole story usually revolves around this number and how quickly it is going up. As a consumer, the lower this number is, the better.

Should I really care? In the short term, inflation isn’t that big of a deal – it generally stays around 3 or 4% annually, so it doesn’t affect you too much on a daily basis.

Where it is important is when you’re looking at retirement. Let’s say you make $40,000 a year and you’re thirty years from retirement. Using a quick rule of thumb, you figure you’ll need $1 million in your retirement account to retire. Not so fast. You’re actually figuring that million dollars without thinking about inflation. The truth is that with 4% annual inflation, you’re going to need $3.24 million in thirty years to equal what $1 million is worth today. Scary? For me, it’s just a reminder that I need to start investing for retirement NOW, not later. Every time you hear an inflation report, remember that it’s a call for you to invest for your retirement.

Loading Disqus Comments ...
Loading Facebook Comments ...
  1. Virgie says:

    How can you say that inflation at about 3-4% per year is no big deal? In normal economics, 3-4% inflation is considered an emergency.

    And also, check out the way the government calculates CPI (consumer price index). They’re cheating! They’re not including gas or food, because these prices are “too volatile.” And if prices go up on electronics, for example, they’re deducting for the “additional value” you’re getting form the higher technology. And then, the ultimate insult, they are assuming that if prices go up on an item, you would buy less of it, so it wouldn’t cost you more. CHEATERS! Real inflation is probably running at 8-10% So holy cow! Try finding a savings account that’s keeping up with inflation!

    And food prices has gone up 17% in the last 12 months.

    Inflation IS a big deal!

  2. Matias says:

    Hi Trent, inflation… a big thing, my country knows it well. On the other way, CPI (In Argentina, IPC)is an index that measures some stores or services (it´s impossible to make a survey of the prices of every store!) and that index is used to compare the costs of goods and services in a period of time. Where is the trick? Every gov´t knows which stores and services are being measured, so, when they do the survey, they “touch down” the prices of only that stores, am I clear enough?
    So, in a short period of time yes, think that your inflation is about 4% (that is not very good, either), but in the long run, think about 10 or 20% per year, if you think I am crazy, check the price of something, eg, a regular new car, 20 or 30 years ago and today, you´ll be amazed. Don´t forget it, you are planning for the long run! So, keep it simple and enjoy your life and family, don´t get crazy about economy, be wise and prepared and.. visit other blogs around! it´s funny how every part of the occidental world have the same problems and issues!
    See you

  3. Macinac says:

    End of 2007 and I think it’s time to revisit this. I’m seeing big increases in food prices, possibly because of corn being used for ethanol as well as for food. Corn has many food related uses: animal feed for producing meat, oil, sweetners, and many others. In addition to this, I was shocked when I went to buy games as Christmas presents for my kids; and that was at Wal-Mart! I am over 65 and my cost for Medicare Part D has gone up. It would be interesting to see what a realistic “basket of goods and services” has done. Interestingly, in my Minnesota town, house prices have not decreased even though sales have collapsed. Theoretically one clever house purchase could make up for a lot of inflation elsewhere.

Leave a Reply

Your email address will not be published. Required fields are marked *