All of a sudden, economists are warning about a threat of inflation. It’s quite a turnaround. Not long ago everyone was wringing their hands over just the opposite, deflation, when prices fall.
Too much of either is bad. When prices and incomes fall in a period of deflation, economic growth can turn into shrinkage and people and businesses find they cannot pay their debts.
Inflation means every dollar buys less, making houses, cars and all other goods and services harder to afford. It can be devastating to retirees who have emphasized safety over growth by favoring fixed-income assets like bank savings and bonds over stocks.
Many economists worry that the federal government’s policy of pumping money into circulation to stimulate the economy could trigger inflation. While the process can be reversed, it can’t turn on a dime.
Even a modest uptick in inflation can seriously undermine your strategy for retirement, college savings and other long-term goals.
Look at the BankingMyWay.com Savings, Taxes, and Inflation Calculator. If you started with no savings, put aside $500 a month for 30 years at an 8 percent return, you could have $708,807 after 30 years.
Assuming you did this in an IRA or 401(k) and paid no taxes along the way, that nest egg would buy what $283,640 buys today, thanks to the corrosive value of inflation at the long-term average of 3.1 percent.
Increase inflation to 5 percent and the savings would be worth only 164,002.
As a rule of thumb, you can withdraw only 4 percent of your retirement savings each year. With inflation at 3.1 percent, your retirement savings would produce enough annual income to buy what $11,345 buys today. At 5 percent inflation, your income would be just $6,560.
That’s not much to show for 30 years of saving.
Since there’s nothing you can do to control inflation, there are four ways to attack the problem: save more every month, reach for a bigger investment return, plan to retire later, expect to spend less after retirement. Use the Retirement Planner to see how changing these factors can affect the outcome.
You can address the first two strategies right away. Trimming spending will allow you to put more aside, and the sooner you do it the better. The Don’t Delay Your Savings calculator illustrates that.
Reaching for a higher investment return is harder, since higher returns generally come with more risk. For the long run, stocks tend to pay much better than bonds or cash. Market-data firm Morningstar Inc. (Stock Quote: MORN), has a useful asset allocation tool for figuring a good mix of investments. Chances are your brokerage, mutual fund companies and bank provide similar calculators.
Morningstar also has tools for finding good stock and bond funds.
If you’re concerned that inflation will rise in the next few months, think about keeping your cash in short-term holdings like certificates of deposit for six months or less, or savings or money market accounts.
You won’t earn much interest. Six-month CDs average just under 1 percent, according to the BankingMyWay.com survey. But by keeping terms short you’ll be able to get at your money to reinvest at higher rates, which generally accompany higher inflation.
Be sure to look at savings accounts. While they average just 0.24 percent, according to the BankingMyWay.com survey some deposit-hungry institutions offer much more. AIG Bank (Stock Quote: AIG) and Bank of Internet (Stock Quote: BOFI) are paying around 2 percent.
How to Prepare for Inflation Now
Inflation Protection for Your Portfolio
Deflation: Why It Matters to You