Inflation, to put it simply, is the rise in prices typically on a year to year basis. That $1.00 cheeseburger that you buy from McDonald's the first year is, maybe, a $1.03 the next year. That means the dollar that you own from a year to year basis decreases in its REAL value. That same dollar can buy you less and less goods and services year after year after year. You get less BANG for your BUCK!
So, is inflation a bad thing? Well, not necessarily. It depends how it's being created. If inflation is being created due to supply shocks, then yes, it can be quite harmful to the economy, however, if it's demand driven then it can be a good thing. Let's dig a little deeper:
Remember the 1970's? Some of you may remember, but if you don't, it wasn't a great time for American Energy consumption. The Organization of Arab Petroleum Exporting Countries (OAPEC) enacted an oil embargo on the United States for political reasons. They cut the supply of oil to one of their top consumers. As a result of the supply shortage or supply shock, the price of oil skyrocketed in America and gas became very expensive. People had to wait in crazy long lines just to fill up a tank of gas, Gas Stations were asked to close on Sundays in order to conserve oil, and average folks were asked not to put up Christmas lights in an effort to conserve energy. Our Automotive industry was also adversely impacted. This supply shock created a huge surge in prices, inflation. Inflation, due to supply shocks, is NOT lucrative to the country's economic growth.
However, when it's demand driven, it can be a great thing for the economy. America is a consumption-based economy and as long as our citizens are consuming goods and services, we're in good shape. You, me, and average joe buying goods, taking out loans to buy houses, to buy cars, Businesses investing in their own growth and expanding, people making more money and spending, are all what we need, as an economy, to grow. With all this consumption, however, the value of these goods and services go up, hence the prices go up, creating inflation. Although demand-driven inflation means that each dollar that we hold will have less bang for the buck, it's being driven by people consuming, which they can do more of as they make more money. So even though each individual dollar is losing value, hopefully our citizens are getting pay raises to balance out the inflation, so they don't feel the effects of the loss in real value. When people's wages don't match the pace of inflation, that's when we're in trouble, but that's a topic for another time.
To put it even more simply, think of inflation as the accelerator of your car and interest rates (in this case I mean interest rates as the cost of borrowing, not the interest rates that you get on a savings account or other investments) as the break. If you want to get from point A to B you have to accelerate, right? But you can't just keep your foot on the accelerator and push it all the way down otherwise you'll get into an accident or you'll burn out your engine. The opposite extreme is also dangerous: if you only keep your foot on the break you'll be a hazard for oncoming traffic and worse yet you'll never move and get to your destination!! So, there's a delicate dance between accelerating and braking that needs to be done. THIS is the job of our central bank.
Now that we know about inflation, how does that affect us, the layman investor, in the game of investing? Well, in short it's a cost that we must take into consideration, but it's a cost that we cannot control, unlike our fees, which we do have a little more control over. I think an example would help:
When I first started my blog and discussed investing with friends, I had a friend ask me why it wouldn't be better to keep his money in a savings account that was accruing 2% interest (In this case interest is growth not a cost) where it's safe. Well, lets think about that? Besides stating the obvious, which is that a 2% growth rate is quite low and there are better low risk options to invest in (Index funds), we have to factor in inflation into scenario. If we know that inflation is a factor that we have to consider on a yearly basis, then let's see what happens to his real growth rate: The Federal Open Market Committee (FOMC) of our central bank forecasts the inflation rate for every year. For 2019 they forecasted inflation to be 2%. Now anything can happen, but usually they're on point. If we have an expected rate of Inflation of 2% that means the prices of our goods and services will rise by 2%, which also means that every individual dollar that he holds will have 2% less bang for the buck. But his savings account is growing by 2%, so that means every dollar that he holds in the savings account will increase in value by 2%. What's the net affect of a 2% interest rate and a 2% inflation rate? 0%. That's right, his money, in his savings account, is not growing in any real value at all.
This is why investing your money is a major key to growing your wealth. And, of course, I'm also not advocating that you should liquidate your savings account. We all need a rainy day fund, but if ALL of your money is just being saved, then that's a problem, because your missing out on so much potential growth out there. And remember, investing in the market through index funds is lower risk than picking individual companies AND it's less costly than hiring someone else to manage your money.
Lets look at a simple investing example to make it even more tangible for us: Inflation eats in to our returns when investing. If we invested $10k into an S&P 500 index fund that had a return of 10% for the year and inflation for the year was 2%, that means our $10k grew by a REAL value of 8%. By Real Value I mean the bang of each buck grew by 8%. Each buck that we invested can now buy us 8% more in value of the goods and services being sold in our economy. It sucks that we lost the 2% to inflation, but it's better than keeping our money in a savings account that has a 2% interest rate, which would result in 0% growth.
Inflation is a KEY concept for the layman investor to understand. Although we have no control over it, we still must factor it into our game plan. Imagine if you invested in mutual funds and had to pay an additional 3% in fees on top of an inflation cost of 2%!!!! You would lose 5% in real value a year! That's why fees are important to keep in check because we have full control over those. We get to choose which assets to invest in. Another reason why Index funds are better investment vehicles than mutual funds.