Inflation has been in the news frequently in recent years. Even if you’re not tired of hearing about it, you’re probably tired of higher prices at the grocery store and at the gas pump.
As of March 2024, US inflation over the previous twelve months was 3.5%. Although inflation has cooled from a 40-year high of 9.1% in 2022, it is still above the Federal Reserve’s long-term target of 2%, which it sees as ideal for employment and stable prices.
Not only can inflation negatively impact the economy as a whole, but it can also make it difficult for the average consumer to save. Let’s take a closer look at how inflation affects savings and what you can do to combat it.
What is inflation?
Inflation measures the increase in prices of goods and services over a period of time – usually a year. When inflation is high, it means that the price of goods and services is growing rapidly. When inflation is low, prices rise slowly.
Inflation is measured by dividing the change in the price of a product or service (or a group of products or services) by the starting price and then multiplying that number by 100. Here’s the formula:
Inflation rate = ((BA)/A) x 100
For example, suppose you want to know the inflation rate of a carton of eggs over the past year. If eggs cost $4 now and $3.50 a year ago, you can calculate the inflation rate with the following equation:
($4 – $3.50) / $3.50 x 100 = 14.29%
However, inflation generally refers to more than the price of eggs. The inflation rate generally measures the overall price change for a broad group of goods and services, such as groceries, health care and utilities. Economists measure this with various price indexes. The most common is the consumer price index, or CPI, which includes commodities such as housing, food, transportation, household goods and health care.
How does inflation affect purchasing power?
You can think of inflation as a measure of your purchasing power. Over time, prices rise and your dollars don’t go as far. In other words, you need more money to buy the same goods and services.
For example, let’s say you spend $100 at the grocery store. That $100 covered your groceries for the entire week. Now buying those same groceries costs $115. You’re not buying anything new, but your $100 doesn’t go as far as it used to.
How inflation negatively impacts your savings
Inflation negatively impacts your savings in several ways. In the short term, inflation can make it more difficult to contribute to savings; if you have to spend more to meet your basic needs, you have less money to save.
Inflation can also erode the value of your savings over time. If you keep money in a traditional savings account – or in cash – it will lose purchasing power over time because any interest income you receive cannot keep up with inflation. So what you save today won’t go very far in the future.
When inflation is high, your savings must earn a very competitive interest rate to keep up. Otherwise, your reserves will actually dwindle over time.
Read more: What is the average savings by age?
How to protect your savings against inflation
While high inflation can be bad news for your savings, there are a few things you can do to protect your money. Use the following tips to minimize the negative impact of inflation on your personal finances:
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Choose a high-yield savings account: When inflation is high, it’s important to keep your savings in accounts that outpace inflation. Fortunately, high inflation often leads to higher savings interest rates. To get the best rates, find a high-yield savings account, some of which have interest rates above 5%.
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Think of CDs: Certificates of deposit (CDs) typically offer higher returns than savings accounts and lock in your interest rate for a specified period of time, known as the term. But there’s a catch: you can’t get your money until the CD is mature, or you’ll be subject to an early withdrawal penalty. If you can afford to hold on to some savings for a while, you can earn a very competitive interest rate over the life of your CD, even if interest rates drop.
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Build an emergency fund: In response to high inflation, interest rates may rise, making it more expensive to borrow money. That’s why it’s helpful to have an emergency savings fund. If your car breaks down or your water heater fails, you can cover the costs without taking on expensive debt.
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To invest: The higher the inflation rate, the faster your money loses value when it’s in a bank account. Historically, investing – although not without risk – can lead to higher returns. This allows you to continue building wealth during inflationary periods.
Check your expenses: Inflation makes it easy to spend more without realizing it. So it never hurts to check your budget. If you haven’t been able to save, you may decide to cut back on your discretionary spending until you have some breathing room.
