How does inflation affect your finances?

The most immediate and obvious impact of inflation you will feel is reduced purchasing power. What is purchasing power? It is the amount of goods and services that a certain amount of money can buy. In the case of positive inflation - that is, if prices rise - the same amount of money will buy you less goods or services.

For example, if you have $200 to spend on restaurant meals each month, and the price of a restaurant meal rises from $40 to $50, you can eat out only four times a month rather than five times as previously. Simply put, inflation will erode your standards of living, unless your income or the money at your disposal grows at least in line with inflation.

If you want to learn more about the topic, read our primer on what inflation is and what causes it.

Central banks such as the US Federal Reserve or the European Central Bank (ECB) often react to higher inflation by raising interest rates. This will inevitably lead to higher interest rates charged by banks on new consumer or mortgage loans. So if you want to take out a loan during times of inflation, you will likely face higher interest rates than usual.

However, if you already hold a fixed-rate loan, you may actually benefit from inflation, as you may be paying lower interest rates now than those who are paying adjustable rates or those taking out new loans today. Also, your (fixed) monthly installments will amount to a lower share of your income and monthly expenses than previously.

One seemingly easy way to beat inflation is by achieving a higher salary. In fact, workers often demand higher wages in times of inflation to match the increase in their living costs as much as possible. Their demands are often met; this is a trend referred to as wage inflation.

However, the benefits of rising wages may be misleading. To offset their rising wage costs, companies often raise prices of the goods they produce or the services they provide, raising inflation even further. This will once again reduce people's spending power, and prompt them to raise their wage demands again - and so the cycle begins anew. This is called a wage-price spiral.

More often than not, wage inflation fails to keep up with price inflation. For example, average hourly wages in the US in January 2023 increased by 4.4% compared with January 2022, but consumer prices increased by 6.3% over the same period. As a result, average real wages - basically, consumers' purchasing power - actually fell by 1.8%

In addition to your daily expenses, inflation can also have a negative impact on your existing savings and investments. For example, inflation will obviously erode the value of your cash holdings. While it is a good idea to keep some cash for daily expenditures or short-term emergencies, you should try to invest as much of your cash as possible during periods of high inflation.

Fixed-rate bonds are also not ideal to hold when inflation is high. This is because inflation will reduce the real value of the fixed coupon payments of your bond. Also, as we discussed above, interest rates will usually rise during periods of high inflation. This, in turn, will make your fixed low-rate bond less attractive, and its market value will fall - meaning that you can only sell it at a loss, should you decide to get rid of it on the secondary market.

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