1. What is inflation
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How does inflation affect your finances?

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Updated
Apr 2024

In 2022 and early 2023, inflation in the US and many other countries shot to its highest in decades. In addition to rising prices for your groceries, inflation can have a wide-ranging negative impact on your finances and your investments. In this article, we'll show you how inflation affects you, from your daily life to the value of your savings.

THE ESSENCE:

  • Inflation can lower your daily living standards and make loans more expensive
  • Higher wages won't necessarily protect you from inflation
  • Avoid keeping your money in cash or fixed-rate bonds in times of high inflation

Reduced purchasing power

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.

Increased borrowing costs

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.

Wage inflation

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%

The impact of inflation on your investments

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.

Ready to take your investments into your own hands? The first step is to find a high-quality and reliable online broker. To find the best one for your needs, check out our broker finder tool.

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Everything you find on BrokerChooser is based on reliable data and unbiased information. We combine our 10+ years finance experience with readers feedback. Read more about our methodology.

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Balázs Szládek
Author of this article
I have 20+ years of hands-on experience as a business journalist, researcher, copy editor and translator covering topics including general news, economic policy, politics and energy markets. I enjoy the challenge of explaining difficult subjects in plain English, helping would-be investors navigate the field of financial markets. I hold a master's degree in American Studies and Political Science.
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