The national average cost of a movie ticket in 2005 was $6.41. By 2019, it was $9.16. That's the work of inflation. The price of a movie ticket, a house, or a semester in college tends to rise over time, sometimes quickly and at other times slowly. That fact is very relevant for your personal savings plan.

Key Takeaways

  • If the inflation rate exceeds the interest earned on a savings or checking account, then the investor is losing money.
  • The Consumer Price Index (CPI) is the most popular way to measure inflation in the United States.
  • Social Security payments are indexed to the CPI, but many believe that is not enough.
  • It is possible to protect savings from inflation by investing in Treasury Inflation-Protected Securities (TIPS), government I bonds, stocks, and precious metals.

How Inflation Shrinks Savings

Let’s say you have $100 in a savings account that pays a 1% interest rate. After a year, you will have $101 in your account. But if the rate of inflation is running at 2%, you would need $102 to have the same buying power that you started with.

You've gained a dollar but lost buying power. Any time your savings don’t grow at the same rate as inflation, you will effectively lose money.

If you are a retiree living on your savings, you can’t keep up the same standard of living if inflation cuts into your purchasing power with every passing year. That is especially true in the U.S., where medical costs tend to rise at a higher rate than many other expenses.

Inflation can hurt well before retirement. Suppose that you are steadily saving money for a specific goal, such as a college fund for your children or a down payment on a home. Your money's purchasing power may decline while you're saving it.

What’s Behind Inflation?

Inflation occurs as demand for goods and services grows. As the total money supply in an economy rises, there is likely to be more demand from consumers. As more people buy more goods, sellers hike their prices.

Inflation is caused by other factors, many of them temporary and limited in their scope. A winter frost can damage the orange crop. That could cause a shortage of oranges and increase their cost. An automaker may be forced to pay more for parts and will pass that increase along to consumers.

Measuring Inflation

How do you measure the effect of inflation on your savings? The government estimates it for you and publishes the results regularly. The Consumer Price Index (CPI) tracks the prices of a variety of consumer goods and services, including transportation, medical care, and housing. The index is published monthly.

While the CPI is the most popular way to measure inflation, it continues to be debated. There are also other methods available, such as the Producer Price Index (PPI).

Inflation in the U.S.

Believe it or not, inflation can be too low. In the wake of the 2008 financial crisis, central banks in the U.S., Japan, and Europe were worried that inflation could go below zero, meaning deflation, or falling prices. The U.S. did experience deflation in housing prices lasting several years in many markets.

During the worst of the crisis, the Federal Reserve targeted a 2% annual growth in inflation to return the economy to health. The bank initiated various stimulus measures that were intended to boost the economy and encourage job creation, therefore putting more money in consumers' hands.

Back in the late 1970s and early 1980s, the Fed fought double-digit rates of inflation and had to deploy monetary tightening measures to combat possible runaway inflation.

Economists will probably never stop debating the policies initiated by the Fed during the 1970s and the 2000s.

How to Safeguard Your Income

If you are a retiree who gets a Social Security payment, you may see an increase in your monthly check from one year to the next. That happens because the government adjusts the payments based on the cost of living, as measured by the Consumer Price Index.

However, that increase requires approval by Congress. A rise of 1.6% was approved for 2020, the same amount as the 2019 increase. The increase was 2.8% in 2018, and it was 2% for 2017. But In 2016, the increase was only 0.3%.  Those numbers were based on the Consumer Price Index, but advocates for retirees argued that was not enough. They pointed out that goods and services used mostly by the elderly, such as healthcare, had larger price increases than the overall index.

How to Safeguard Your Savings

The primary way to beat inflation is to invest your savings for a better return than you can get in money market accounts or savings accounts. Investing in virtually anything else inevitably involves more risk than an FDIC-insured account. But you can choose investments that are appropriate for your risk tolerance.

For example, retirees might want to consider Treasury Inflation-Protected Securities (TIPS). These securities adjust the interest payouts you get based on changes in the CPI. The principal payment you get back will also be adjusted for inflation. Even if prices go down over the investment period, you will still get back the original principal if you purchased the security when it was first issuedl. However, government I bonds can be a better deal for small investors.

Returns on stock investments generally tend to beat inflation. Investors who want to avoid the volatility associated with individual stocks might opt for mutual funds. A passive indexing approach is often best since it does not depend on the stock-picking abilities of any particular fund manager. Exchange traded funds (ETFs) usually have lower fees than other index funds.

Investing a portion of savings in precious metals, such as gold or silver, is another way to outrun inflation. Traditionally, people bought gold and silver coins. Today, there are also many precious metals ETFs available for investors. An asset allocation that adds a little bit of gold to a stock portfolio can also produce more consistent returns.

The Bottom Line

Inflation tends to cut into a consumer’s purchasing power over time. Fortunately, there are ways of preserving the purchasing power of your savings. That means investing, but keeping your level of risk moderate.