The current annual inflation rate is only 1.7% then why do my bills seem higher than last year? This might be a common question everyone ask yourself right? So let’s see how important inflation is and how it can affect our investments.
What Is Inflation?
Definition – When economy experiences Inflation, i.e. when the price level of goods and services rises, the value of currency reduces.
The Bureau of Labour Statistics reports on the average level of prices when it releases the consumer price Index (CPI).
What is CPI?
Definition – A comprehensive measure used for estimation of price changes in a basket of goods and services representative of consumption expenditure in an economy.
Description: The calculation involved in the estimation of CPI is quite rigorous.
Who’s Basket of Goods?
The CPI can come under scrutiny as many of them find that government basket does not reflect their experience.
For example, the CPI rose 1.7% for 12 months in 2016 which was a passable increase. Excluding food and energy, prices rose up to 2.1% for the 12 months.
Effects on Investments
- Purchasing power at risk: When there is a rise in prices, only a fixed amount of money has the power to purchase fewer goods. Cash alternatives may also not be sufficient to keep pace with rise in prices.
- Real rate of return on investments is reduced due to inflation & if taxes are taken into consideration, the real rate of return may be reduced further.
- The actions of Federal Reserve can be influenced by inflation. If at all the Fed wants to control inflation, it can reduce the amount of money circulation by various methods.
Less money supply can lead to less spending which in turn would lead to lower inflation & prices.
Ways to stay ahead of inflation
- Invest in Equities/Equity Mutual Fund
- Invest in dividend paying stocks
- Assets like gold and real estate
- Diversify geographically
- Inflation-Indexed Bonds
- Re-align your portfolio
When Inflation is low, it’s easy to know how prices are affecting household budget.
When inflation is high, it may be tempting to make changes according to increasing prices.
The Best solution to this would be to develop a sound investment strategy that takes both possible scenarios into account.
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