Inflation is something that we seem to hear about everyday yet most of us know little about it. This is unfortunate and dangerous because inflation is one of the most powerful financial forces out there. It has brought down governments and destroyed entire economies in the past.
If that wasn’t bad enough inflation can also destroy your investments and undermine your financial position. It is also one of the most dangerous threats to retirees and their investments. Retirees are often very vulnerable to it because they often live on fixed incomes.
What Causes Inflation
The most common cause of inflation is simply an increase in the money supply. If there is more money in circulation or use the value of currencies falls. Historically this was why people favored gold or silver coins over paper money.
Governments or counterfeiters could simply print more paper money but precious metals were rare and hard to come by. There have also been cases in history when governments and others deliberately sabotaged currencies by printing and distributing large amounts of counterfeit money.
An even more damaging cause of inflation is lack of faith in the government. This is why hyperinflation (astronomically high inflation) often occurs in nations that lose wars or undergo revolutions. It is also why inflation is so common in third world nations and Communist countries where people believe the government is worthless so they think the money is worthless. The less faith people have in the government, the less faith they will have in its’ money.
Another cause can be currency trading. Speculators can cause inflation by refusing to buy a nation’s currency or by dumping large amounts of it on the market at once. Some observers wrongly blamed currency trader George Soros for the collapse of some Asian currencies in the 1990s. In today’s world the value of currency as determined by trading in London can cause inflation. If large amounts of currency would suddenly leave a country through electronic transfers, inflation could result.
Some economists also believe that government debt can cause inflation. Nations that take on a lot of debt such as Argentina have undergone hyperinflation. The debt reduces the country’s buying power and the value of its money.
Inflation’s Effect on Money
The effect of inflation on money is easy to see it reduces the buying power. If the inflation rate is 10%, then a dollar will actually be worth 90 cents. Under those circumstances $100 in a bank account would be worth $90 and so on. In inflationary periods prices go up because businesses earn less profit from what they sell.
One reason why inflation is destructive to retired people is that it can wipe out investment gains. If the rate of inflation exceeds the interest rate on an investment such as a fixed annuity the funds in that vehicle will lose money. If the rate of inflation is 9% and your annuity paid 4% you would lose 5% of your money.
Protecting Yourself from Inflation
The way to protect yourself from inflation is to put a large percentage of your funds in investments that increase in value faster than the rate of inflation.
The historic rate of inflation in the USA is around 4% but the stock market usually grows in value by 11% a year. Therefore indexed investments (vehicles in which the return is pegged to the S&P 500 or another list of stocks) will usually beat inflation. Putting part of your funds in an indexed fund or an indexed annuity can protect them from inflation.
Something you will not have to worry about is inflation destroying Social Security. Social Security has an automatic cost of living increase. That means Social Security payments are raised by a rate that matches the rate of inflation every year. Inflation is something you should be aware of but it is not something you should lose sleep over. There are ways to protect your money and your investments from it.