How Inflation Affects Spending and Retirement

How Inflation Affects Spending and Retirement 

Reading time: 7 minutes

Alongside employment and growth data, inflation is among the most widely used terms in economic discourse.

Inflation Defined

Inflation is the rate at which prices for goods and services increase in a country over a specific period, typically a year. It is widely considered as a measure of the cost of living. For example, let’s assume that the overall cost of goods/services in the US increased by 2.2% in August 2023 compared to a year ago. Essentially, this would mean that the price for the same good or service, which had cost US$100 in August 2022, would rise to approximately US$102.20 in August 2023. 

Inflation occurs naturally in an economy. Moderate inflation indicates a healthy economic environment, with most central banks setting their inflation targets around 2.0%. Rising costs can occur due to several factors, including demand-pull inflation (reduced demand and excess supply), cost-push inflation (increased input costs lead to greater production costs, often resulting in higher prices for goods and services), and inflation expectations (if firms forecast higher inflation in the near future, they may raise the prices of their goods and services based on this expectation). 

How is Inflation Measured?

The Consumer Price Index (more commonly referred to as the ‘CPI’) is extensively used to determine the inflation ate for consumers in an economy. In the US, the Bureau of Labor Statistics (BLS) is tasked with publishing a monthly report that computes the rate of change of a basket of goods and services a typical consumer purchases. 

Within the CPI report, you will also be able to view CPI inflation data that excludes volatile components: food and energy, as well as individual changes in price levels for certain goods, such as food, energy, shelter, and transportation. 

As you can see from the chart below, inflationary pressures have slowed considerably across global economies since early 2023, with many closing in on their respective central bank targets.

In addition to the CPI report, the Producer Price Index (or ‘PPI’), which measures the price of a typical basket for producers (firms), is another widely followed indicator released monthly by the BLS.

Rising inflation is a primary concern for policymakers, economists, traders, investors, and the wider public. If inflation rises faster than income or savings, this can influence lifestyles, affect the value of pensions, and cause uncertainty about the future. 

Inflation and its Effects on Spending and Retirement 

Reduced purchasing power is one of inflation's most recognised effects, influencing spending, retirement planning, and pension plans. If inflation outpaces income, pension income (assuming your pension value remains the same and does not increase to factor in inflation) and investments, maintaining your standard of living in such an environment could be challenging. This can result in retirees spending more of their income to cover their current needs. For those still in the labour force, elevated inflation may lead to employees demanding higher salaries to keep up with increased prices, perhaps setting in motion a ‘wage-price spiral’ – a cause-and-effect association between rising prices and salaries. 

Higher price pressures are also inversely correlated with the unemployment rate. This means increased inflation can trigger higher unemployment and potential recession. Consumers with low incomes, those who tend to devote a larger percentage of their salaries to goods and services, can be particularly impacted by increased inflationary pressures unless they have sufficient savings to fall back on. 

According to the 2023 US Survey of Household Economics and Decisionmaking (SHED): ‘Some groups continued to experience financial stress at higher rates than others. Lower-income adults were more likely to experience material hardships, including not paying all bills, not always having enough to eat, and skipping medical care because of cost. Additionally, the gap in financial well-being between parents of children under age 18 and other adults widened, as parents saw a continued decline in well-being in 2023’.

Increased inflation can also lead to higher interest rates. From early 2022 until mid-2023, the US Federal Reserve increased interest rates 11 times to 5.50% amid elevated inflation. As shown in the chart above, inflation in the US reached 9.1% in mid-2022, levels not seen since the 1980s. In the UK, inflation reached an eye-watering 11.1% in October 2022, which led the Bank of England to raise rates at 14 consecutive meetings to 5.25%. 

How to Combat Inflation?

In the US, many retirees, those planning for future retirement savings, or investors often seek inflation-adjusted investments such as Treasury Inflation-Protected Securities (or ‘TIPS’) to help tackle inflation. They also tend to diversify their investments across gold – often viewed as an inflation hedge – real estate (think Real Estate Investment Trusts [REITs]), and stock indexes (like Index Funds, and Exchange-Traded Funds [ETFs]).

While interest rates increase borrowing costs and reduce spending, they can give savers more ‘bang for their buck’ regarding return on investment. Therefore, investing in high-interest accounts is another option to help offset price rises. 

Inflationary pressures can also encourage consumers to adopt new spending habits to help lessen the effects. This can involve a cash-flow plan that helps budget spending. Luxury items are also often shelved, and bulk buying and promotional items are embraced. Additionally, consumers may abandon brand loyalty consumption and seek alternative, cheaper brands. 

FAQs:

1. What is Inflation?

Inflation measures how fast prices rise for a typical basket of goods and services over a specific period. The CPI  is one of the most commonly used indexes to measure the inflation rate change.

2. How does inflation affect spending and retirement?

One of the primary effects of inflation is the reduction in purchasing power. As prices rise, if your income/savings do not rise at the same rate, your money buys less and can influence living standards.

3. How can I protect my savings and pension from inflation?

While everyone’s goals and lifestyles differ, there are several things you can do to help protect your savings and income from inflation. These can include diversifying investments, creating a budget plan and organising spending.