Everything has become more expensive, from milk in the supermarket to petrol at the gas station. In other words: Germany and Europe are currently experiencing unprecedented inflation. Record inflation is hitting everyone, including your wallet. What inflation means and how you can protect your money from it: 5 important facts on the subject.
100 dollars are 100 dollars – this statement cannot be shaken at first. However, the goods or services you can buy with these 100 dollars will change over time. Because more expensive goods and goods may decrease the value of your money. The technical term for this form of depreciation: is inflation.
The 5 most important facts on the subject:
1. The inflation rate is currently rising
Most people associate the term inflation with rising prices. But, in fact, the inflation rate (also the rate of increase), i.e., the rate of price increases, has risen significantly in recent months – according to initial estimates by the United States Census Bureau, it was 7.7 percent in October 2022.
In 2020, the rate was even lower – at 1.23% percent, the lowest level since the financial and economic crisis of 2009. This was mainly due to the effects of the corona pandemic. For example, the temporary reduction in VAT contributed to the low annual inflation rate – especially in the second half of 2020.
In principle, an inflation rate of less than two percent is not considered a good situation. According to many experts, it is not compatible with healthy economic growth. That is why the Federal Reserve tried to boost inflation with low-interest rates.
The majority of experts consider the currently high inflation rate to be temporary. However, in the longer term, they expect a rate that is significantly closer to the Fed Reserve target of two percent.
2. A stable price development ensures planning security
Consumers want stable prices. Whether for groceries, heating oil, or building materials – if you know the prices, you can plan well financially. Especially with construction projects or other major financial projects, suddenly rising prices can quickly lead to nasty surprises.
The Fed Reserve keeps an eye on inflation. The target is an inflation rate of around two percent. The reason is that an inflation rate close to two percent is appropriate for stable economic growth. In this way, consumers and companies are encouraged to make purchases and investments promptly instead of putting them off. At the same time, comparatively moderate inflation stands for a stable, i.e., predictable, price development.
3. Inflation destroys purchasing power
Stable prices are desirable for daily shopping or when planning a house. However, stability becomes a problem when it comes to investments. Because they should increase in value and not stagnate or even decrease. Even if two percent less purchasing power in one year doesn’t necessarily mean much – calculated over a period of 10 or 20 years, the difference is clearer.
This becomes clear in an example calculation. This shows how the purchasing power of 100 dollars develops with an annual inflation rate of two percent:
|Year||Purchasing power at the beginning of the year||Inflation rate||Year-end purchasing power|
|2021||100.00 dollars||2.0 percent||98.00 dollars|
|2022||98.00 dollars||2.0 percent||96.04 dollars|
|2023||96.04 dollars||2.0 percent||94.12 dollars|
|2024||94.12 dollars||2.0 percent||92.24 dollars|
|2025||92.24 dollars||2.0 percent||90.39 dollars|
|2026||90.39 dollars||2.0 percent||88.58 dollars|
|2027||88.58 dollars||2.0 percent||86.81 dollars|
|2028||86.81 dollars||2.0 percent||85.08 dollars|
|2029||85.08 dollars||2.0 percent||83.37 dollars|
|2030||83.37 dollars||2.0 percent||81.71 dollars|
|2031||81.71 dollars||2.0 percent||80.07 dollars|
The calculation example shows: In real terms, 100 dollars have lost almost a fifth of their purchasing power in eleven years. Even if it is creeping, inflation ensures that 100 dollars are worth significantly less after 10 years.
4. Anyone who uses fixed-term deposits or call money falls into the real interest rate trap
An additional difficulty for savers is the so-called real interest rate trap. This is a problem, especially given the current high level of inflation. Because investors are still getting very low-interest rates on many investment products.
Even if your money in the account possibly yields interest again, the interest gain is usually eaten up again by the high inflation: The – nominal – increase in value in figures on the account statement does not apply in reality, where inflation is hitting. The real interest rate trap is poison for your finances: If you are currently investing in overnight or time deposit accounts, you will lose money.
5. It is possible to counteract inflation
In view of the high inflation rate and the current low-interest environment, parking money in a savings account, current account, or time deposit account is not a practical option. A good way to counteract inflation is: Invest your money with a chance of a return. Which investment is right for you depends on your financial situation, your circumstances, and your savings goals.
One way to invest is to buy real estate. Then, you can use this as an investment and rent it out. Although real estate prices are already quite high in many places, with the help of good advice, you could still achieve a return that is higher than the inflation rate after a few years, thanks to the additional rental income and an increase in the value of the property. Or you can live on the property yourself.
By the way, a higher inflation rate can have a positive effect if you have financed the property with a loan. The reason: if money is worth less, the real debt burden decreases.
Frequently asked questions and answers.
How to counteract inflation?
A good way to counteract inflation is to invest in a high-yield investment. Instead of parking money in a savings account or putting it in a call or time deposit account at a low-interest rate, investing in equity funds, for example, is worthwhile. Due to the return opportunities, equity funds are better able to compensate for the inflationary loss in the value of money, especially over a long investment period – and also make profits at the same time.
How is the inflation rate measured?
Imagine a typical shopping cart: bread, milk, cheese, some meat, and a bottle of wine. Now, with every purchase, write down what these goods cost individually. This way, you can easily see how much the prices are going up or down.
Similarly, The United States Census Bureau measures the price increase in the country every month. The products that an average US household needs are in an imaginary shopping basket. This primarily includes water, gas, and food, but also expenses for housing, health, and leisure. Added together, this results in the so-called consumer price index. The inflation rate is then calculated on this basis.
How does the price increase?
There are various reasons for rising consumer prices. For example, a demand that is greater than the supply. Or costs that change for companies, for example, when raw materials become more expensive, or wages rise. In order to keep making profits, companies pass on increased costs to consumers.
Inflation also increases when central banks increase the money supply by giving more money to a country. After all, where there is more money, more money can be spent. As demand increases, so do prices.
Read also: Deflation – definition, causes, and effects