During an economic downturn it seems investors and consumers are always fixated on the state of our economy and as a result, the focus is on next day, next week and next month. Considering that unemployment during these periods can rise as high as 10%, it's very easy to understand the short-term perspective with which many concern themselves. After all, it's hard to tell someone to think about the next year or two when they are concerned about the security of their employment. Indeed, if you are without a stable source of employment, not much else matters in terms of the state of the economy.
As hard as it is to believe during an economic downturn, economies recover, and in all likelihood come out even stronger than before. History is a very powerful indicator. Over the last 100 years, the United States has experienced numerous recessionary periods, including the Great Depression of the 1930s. In the end, we came out stronger. In addition, recessions encourage consumers to save, and a country with a net savings position is certainly stronger than a country with a net borrowing position. It's easier for the country to stimulate consumer demand when consumers actually have the means to buy things. (For more, read Recession And Depression: They Aren't So Bad.)
However, along with economic healing comes a necessary consequence: inflation. We are often taught in basic economics that inflation means "too much money chasing too few goods." Actually, a more accurate definition of inflation is simply too much money. Somewhere in this world there will always be goods or services for that money to find a home. (For more on inflation, read the Inflation Tutorial.)
Too much money can be a necessary consequence of financial recovery. The Fed's stimulative efforts during the financial crisis of 2008-2009 are an example of that. Moreover, as that recession became global, more and more countries expanded their balance sheets to aid their economies. In 2009, we saw the central bank really play its role as the "lender of last resort."
The Hidden Tax
Why is inflation so important not only to investors, but to average working Joes and their families? If you thought government taxation was the biggest threat to your hard-earned income, you are being victimized by the ravages of inflation.
Simple math reveals that inflation is a far more onerous tax than anything to come out of Congress. During years with 4% inflation, anyone with an interest-bearing account yielding 4% is effectively paying a 100% tax on interest income. In other words it makes no difference if you put your money in a savings account earning zero percent during periods of zero inflation or a savings account that pays you 4% a year during years when inflation is 4%. Either way, the effect is a "tax" that leaves the individual with no real income. Whatever money is spent comes out of capital.
In fact, most people would find it outrageous to pay an income tax of 120%, yet folks don't realize that 6% annual inflation is the economic equivalent.
The Light at the End of the Tunnel
Fortunately, there's light at the end of the tunnel in terms of what individuals can do to minimize the consequences of inflation, and in many cases, benefit from it. Once you understand the causes and consequences, the next step to combat the ravages of inflation is to learn to protect yourself from it.
Inflation doesn't occur over night. But you will see signs. When a recession hits, inflation will almost certainly follow, but not always immediately. Consumers tend not to spend and financial institutions and other businesses must work on deleveraging their balance sheets. But inflation is not something that needs to be timed in order for people to minimize its impact on the purchasing power of money.
What's important is that people realize the hidden taxation that inflation brings and how to arm yourself for its to erode your savings. (To learn more, see The Importance Of Inflation And GDP.)
For young individuals just getting into to the workforce or soon to be joining it, the ultimate tool against inflation is very simple: continue to invest in yourself. With decades of earning power in your future, the most significant way to benefit from the general effects of inflation is to continually improve in your particular craft.
A school teacher for example can invest by pursuing additional degrees which leads to pay raises and increased job security. Whatever it is you do always continue to invest in yourself. Doing so will give you the most bang for your buck.
Also, and this is important, spend less than you earn and avoid credit cards as much as possible. The secret to financial independence is to simply spend less than you earn, period. It's hard for me to sympathize with folks who are losing million dollar homes and seven-figure salaries and finding themselves broke. Sure the economy can be a catalyst, but the real issue is that many people live above what they can truly afford. A job loss is painful, but when you know you have no debt obligations, it's easier to pick yourself up and move on to something else. (For more, read Invest In Yourself With A College Education.)
Regardless of the state of the real estate market, owning a home is still the best investment you can make if it's done for the right reasons. Those reasons are that you desire to own the home as a place to live and not a property to flip. And now more than ever, buying a home is an excellent idea.
The most obvious example was the residential real estate market in 2008 and 2009. It was a buyer's dream. You could have negotiated down a price of a home to over 50% less than what they sold for only three years earlier. But aside from getting a good price, taking on long-term mortgage debt today will benefit the borrower at the expense of the lender. Inflation decreases the purchasing power of money, so if you take a 30-year mortgage today, you will likely be paying back that mortgage with less valuable dollars. On top of that, buying at depreciated levels vastly increases the likelihood that your home will appreciate in value over time.
And yes, every month you make a mortgage payment - assuming it's a principal and interest payment - is like putting money into a savings account. When home prices are depressed and inflation is a worry, it can be a great time to buy a home. And if it's your first home, you have money to make a suitable down payment (10-20%) and your credit is good, banks are happy to lend to you. (To learn more, check out Top Tips For First-Time Home Buyers.)
For those about to retiree, it's not as simple because unfortunately, time is not on your side. If you have been doing the things outlined above - you have little or no debt and own a home (which by should be close to mortgage free), then the best options are investments like Treasury inflation protected securities. Exposure to 'AAA'-rated corporate bonds may also be wise for part of your portfolio. Also, it's a good idea to have a little exposure to stocks, particular large cap value names. These companies tend to do relatively well in most economies and offer respectable yields.
Knowledge is Power
Understand that the hidden effects of inflation are the key to protecting yourself. Inflation affects us all in some fashion. You don't need to know that inflation is happening this month or next to prepare yourself. You just need to understand that attention to simple financial prudence - avoidance of debt, living below your means and making sensible investments - will likely leave you better protected in the future. (For a complete look at the causes and implications of inflation, see our Inflation Tutorial.)