Since raising the Federal Funds rate last December for the first time in almost a decade, the Federal Reserve Bank raised rates yet again last month, projecting steady growth in the economy. As rates begin to rise again, it is becoming more important to acquaint yourself with inflation, how it ties to interest rates, and how it can affect you and your investments.
Are you saving for retirement, for your children’s education, or for another long-term goal? Are you investing in the market with an IRA, a target retirement fund, or any other investment vehicle? If you answered “yes” to any of these questions, it pays to be familiar with inflation and the inflation rate: how it evolves, and how it can affect your savings.
What is inflation?
Inflation is the rise in cost of goods and services over time. It is essentially a supply and demand issue – when the economy is growing and people have more disposable income or easy access to low-cost loans, the price of goods and services rise to meet that demand.
How does inflation relate to the Federal Interest Rates?
Inflation is the result of a series of events. The Federal Reserve has an ideal target for inflation, and they manipulate interest rates to try and keep inflation in that ideal range. When they suspect that inflation is heading too high, they raise interest rates, which in turn lowers consumer demand, which finally coaxes prices to level out or decrease. In the big picture, it is a normal part of the economic cycle.
Why is it important for me to know?
First it should be noted that inflation is not a bad thing. It usually coincides with a growing economy, which means more jobs and better incomes.
Deflation, on the other hand, tends to have the opposite effects. Our Federal Reserve and policy makers are always looking to achieve their “Goldilocks Economy” (and, yes, that is a real thing!) and their greatest tool is the ability to direct interest rates.
However, with that said, you do need to respond to inflation to keep your finances improving.
Let’s say you invest in some stocks, bonds, mutual funds or other investment vehicles. If your assets aren’t keeping up with inflation then you are losing purchasing power, which in more pragmatic terms means you are losing money.
Or let’s say you don’t invest, you just want to build up savings. Over a 30-year period, a conservative annual inflation rate of 3 percent would reduce the purchasing power of a $100,000 retirement savings account to only $41,322.
What can I do to improve my financial well-being?
For starters, it helps to diversify your portfolio. A diversified portfolio is going to expose you to multiple asset classes (stocks, bonds, cash, and real estate among others).
Stocks, historically speaking, are the best way to beat inflation. Bonds are usually good at keeping pace with inflation and providing stability in the portfolio. Cash is important, we need to keep a reserve to pay the bills and cover us in emergencies, but it does not keep up with inflation over the long term. Diversification is a good way to cover all of your bases.
Lastly, work with a financial expert with your best interests in mind. An advisor can help you identify a plan. Certain expenses tend to inflate at a higher rate than basic goods and services, such as education and healthcare.
So depending on your goals and concerns you may need to operate under a more aggressive inflation assumption in some cases. An advisor can help you make the best decision to match your financial goals.
To speak with a financial advisor, contact Shelly Geweke (503-423-8519; email@example.com) and schedule a no-cost, no-obligation consultation today.
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