Why Is Inflation Bad? 3 Effects Of Inflation

The latest inflation report piled bad news atop of bad news. The June Consumer Price Index (CPI), which the Bureau of Labor Statistics uses to track price changes for 80,000 goods and services, indicated that prices rose 9.1% over the past year.

The report continues a trend of high inflation that started last year. In 2020, the annual rate of inflation was 1.2%. In 2021, it was 4.7%.

But what does this continued high inflation mean? And does anyone actually benefit from high prices?

What Is Inflation?

Simply put, inflation is an economic term used to describe rising prices.

Inflation occurs when people spend more on the same amount of goods and services than they were, say, a year ago.

When everybody pays more and gets less for it, it can have some profoundly devastating effects on the economy—and some people get hurt more than others.

“In every economic environment, there are winners and losers and inflation is no exception.  However, the longer high inflation persists, the harder it is to find winners,” says Jeanette Garretty, chief economist at Robertson Stephens, a wealth management firm based in San Francisco. “Ultimately, high inflation seeps into the nooks and crannies of every balance sheet and income statement.”

Here are some reasons inflation can be so devastating to everybody’s bank accounts.

3 Ways Inflation Hurts Consumers and the Economy

1. Less Purchasing Power

The most obvious impact of inflation is that it hurts your purchasing power. If you can’t buy as many goods and services as you did before inflation, your quality of living will eventually diminish.

“Essentials will take precedence over non-essentials as everyone tries to stretch the purchase side of their budget,” says Angelo DeCandia, a professor of business at Touro University. “Think more money spent on groceries and gasoline, and less spent on travel and entertainment.”

Less purchasing power really hurts families that were already experiencing financial hardship, says Dan North, senior economist at trade credit insurer Allianz Trade.

“Inflation hits the lowest-income families harder because items such as gasoline and food make up a much larger portion of their budgets, leaving less for discretionary spending,” North says. “So, for example, where they used to have money to go out to dinner, even fast food, or [go to the] the movies once a month, now they won’t at all.”

And if you’re already stretching your budget to the limit, it’s harder to make adjustments to reduce your costs. For instance, if you’re already using the cheapest toilet paper or paper towels on the shelf, you can’t trade down.

In fact, a 2021 study from the University of Pennsylvania found that lower-income households had to spend about 7% more on goods and services last year compared to 2019 or 2020, while higher-income households had to spend 6% more. Remember, the annual rate of inflation for 2021 was 4.7%.

2. Less Savings

If rising prices for essentials is eating into your budget more than normal, you probably aren’t putting as much money into a savings account. A June 2022 Forbes Advisor-Ipsos survey found that 42% of respondents were saving less money than usual.

“Inflation makes all of our income and savings less valuable,” says Todd Steen, professor of economics at Hope College in Holland, Michigan.

If you’re not able to save as much as you used to, you may be less prepared for financial emergencies, forcing you to rely on costly credit cards or loans to pay unexpected bills.

And even if you have money in savings already, that decreased purchasing power means your emergency fund might not stretch enough to cover a financial crisis during an inflationary period.

If you have $1,000 socked away for a rainy day, you’re certainly better off than not having it. But here’s an example of how inflation can eat at the value of your savings.

Car repair prices went up 9% from June 2021 to June 2022 according to the CPI. If you had a $900 car repair in June 2021, in June 2022, that same car repair would have been $981. Suddenly your $1,000 saved up is a little less valuable.

And this trend may continue for a while, according to Steen.

“Inflation is a difficult problem to get rid of in an economy, because when prices increase, workers want to have higher wages and salaries to keep up,” he says. “This can lead to future price increases, and the cycle continues.”

3. Loss of Goods and Services

Some industries do pretty well during inflationary times, particularly ones in which you can’t hold off your spending indefinitely, like supermarkets, gas stations and funerals—but some businesses are completely devastated.

That’s because when inflation runs rampant, consumers spend their money on products and services that they absolutely need, and hold back on what they don’t.

You’re going to get your car repaired if you need it. You’ll keep spending money on food.

But you might not take your kids to a trampoline park. You might instead opt for a free city playground with the youngsters, instead. Decisions like that are understandable when prices are high but collectively, they can damage segments of the economy.

“That could mean your favorite pizza place closes, or your nail salon drops a service because it’s become too costly,” says Callie Cox, an investment analyst at eToro, social investment and multi-asset brokerage company with 10 offices worldwide.

Does Inflation Eventually Go Down?

Yes, inflation will eventually decrease.

Economists want inflation to stabilize, so that prices either level off or creep up gradually over time.

If prices go down enough, where inflation goes below 0%, that’s called deflation. Deflation comes with its own slate of negative effects—when customers aren’t buying products or services, business owners may lower prices to be more competitive, but they may also need to lay off workers.

Deflation can lead to a recession, which takes place when the economy shrinks instead of grows.

Read more: Is The U.S. Economy Heading For Stagflation? 

Deflation can also contribute to a depression—which is more severe than a recession—as it did during the Great Depression. For one example, consider that between 1929 and 1932, real estate prices in New York City dropped by 67%.

Plunging prices sound great in theory,  but if you’re out of a job and barely have any money, even cheap stuff is going to be too expensive.

The U.S. central bank, the Federal Reserve, never wants inflation to drop too much – or climb too much. The sweet spot is considered to be a rate of 2% annual rate of inflation, which allows households and businesses to keep spending (and saving) as prices go up bit by bit over time.

If inflation is higher than 2%, the Fed generally will raise the federal funds rates (which leads to increased interest rates) to try to slow the economy’s growth and lower inflation. If inflation is under 2%, it will often lower interest rates, to get consumers excited about borrowing money (say, to purchase a new car or home), which tends to keep the economy humming along.

What’s Next For Inflation in the U.S.?

It’s hard to say what’s next. The Federal Reserve has already raised rates several times this year and is expected to do so until the fed funds rate reaches 3.5%. This is expected to push prices downward, but it comes with some risk of entering a recession. A recent Reuters poll of economists determined that the country has a 40% chance of going into a recession.

If inflation continues to run amok, DeCandia says that educational and career choices could start to shift.

“We’ve all heard the story of how Grandpa had to drop out of school to help support the family,” he says. “Could that become a new reality with sustained inflation? Even if it were to be less dramatic, the impact of higher inflation could change the course of education for younger people in several ways.”

“In some cases, it may even eliminate grad school dreams,” DeCandia says.

DeCandia also says some people may be more likely to choose the job with the highest salary and put some of the other extras—like personal fulfillment in your career—aside.

If consumers change their education or career plans in order to survive high inflation, it could be to the detriment of their long-term financial health.

If people are struggling to save for an extended period of time, it may make it harder to plan to buy a house, save for vacations or send kids to college, says DeCandia.

“For some people, the whole idea of owning a home may have to be moved to the back burner,” he says.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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