Inflation: what it is, why it matters, and why people always use milk as an example.

*Disclaimer: this isn’t professional financial advice — just regular, educational info to help you learn! Investing comes with risks (yes, even losing money), and past performance DOES NOT guarantee future results. Always do your own research!

Hello, hello.

Today, we are going to talk about inflation and why it is so much more than an annoying thing that happens every year. Instead, it is an extremely important factor when it comes to your money, particularly your savings.

So, what the hell is inflation? You have most likely heard a reference to inflation more than once. It is common to hear complaints and fears surrounding rising inflation. However, the idea is rarely defined or explained.

Here it is: Inflation is the increase in the price level of goods or services over time.

Now this is a nice little definition, but what does it actually mean? It means that prices of goods and services (aka tangible and intangible items like books and haircuts, respectively) are more expensive than they used to be. As a result of them costing more, the money you use to pay for them has less spending power.

Here’s an example:

I get a haircut once a year. Last year I paid 100 dollars for my haircut. Given that inflation has risen around 3 percent (2.7% to be exact). My haircut this year would cost me 103 dollars. Meaning, while I only needed 100 dollars last year, to have the same spending power this year, I would need 3 more dollars.

Now you may be saying to yourself, well, whatever, 3 dollars isn’t that big of a deal, so I am not going to worry about inflation. While I wish we could live like that, the reality is that it would massively affect you in the long run.

Here’s why:

3% is the amount that inflation has increased between this year and last. When we look at a 10-year period, from 2015 to 2025, for example, the overall rate of inflation was around 35% (35.6% to be exact). This means that in our haircut example, if it cost 100 dollars in 2015, it would now be 135 dollars. If this still does not feel like enough money, imagine the haircut cost 1000 dollars in 2015 (I know, lol, but imagine), it would now in 2025 cost 1350 dollars.

Ok, so now we understand how inflation affects our spending, but why does inflation happen? While it would be so lovely to be able to point to one person or factor, it is really the result of many different factors working together. The easiest way to understand them, in my opinion, is to look at the three different types of inflation. While this may sound like inflation is getting more complicated, understanding the reasons actually simplified it a lot in my head, so hopefully the same will be true for you. If not, my apologies in advance lol.

1) Demand-pull Inflation:

When there is more demand than supply, prices go up. For example, if there is a surge in people buying cars to the point where there are more people trying to buy cars than one factory is producing, the price of the cars will increase. A helpful phrase to remember this type of inflation is “more money chasing the same amount of goods”.

2) Cost-push Inflation:

When raw materials become more expensive, prices go up. For example, if the metal used for making cars increases in price, the price of the vehicle will increase. A helpful phrase to remember this type of inflation is: higher material costs lift the price of goods.

3) Built-in or Wage-push Inflation

Expectations that prices will rise lead to workers asking for higher wages. In order to cover higher wages, companies increase their prices. A helpful phrase to remember this type of inflation is: expecting rising prices, higher wages demanded lead to companies charging more.

Now that we understand the different types of inflation, we can look at which institutions and environmental factors affect them. When it comes to inflation, the following are the most common players institutionally and situationally speaking: Federal Reserve decisions, bank lending, government policies, global events, supply chains, and expectations.

1) Demand-pull “players”

a) Federal Reserve decisions: when the Fed lowers interest rates, more people spend,

which causes higher prices.

b) Government policies: when the government encourages spending, through stimulus

checks, for example, people spend more, which causes prices to rise.

c) Bank lending: when banks lend more money, people are able to spend more, and

prices rise.

*remember: more money chasing the (same) amount of goods.

2) Cost-push Inflation:

a) Global events: when there are disruptions such as wars, natural disasters, or

pandemics, the cost of raw materials rises due to supply issues.

b) Supply chain: when any part of a supply chain process becomes more expensive, so

does the product. This can be due to factories closing, delivery delays, worker

shortages, etc.

*remember: higher material costs lift the price of goods.

3) Built-in or Wage-push Inflation

a) Government policies: when the government mandates that wages be increased,

companies then raise their prices to adjust for what they must pay employees going

forward.

*remember: higher wages lead to companies charging more.

Congratulations, if you have made it this far, you are now an expert on inflation!

We are now going to look at how to inflation-proof your savings goals. Unfortunate spoiler alert: there is no magic wand or trick that will do this. Rather, it is a matter of doing math and adjusting your targets.

Say I want to have 200,000 dollars saved by the time I am 65. In reality, what I mean is that I want to have a value of 200,000 dollars at my disposal when I am 65. Now, these may not sound like different scenarios, but trust me, they are. One doesn’t take into account inflation, while the other one does. The result is dramatically different.

Let me explain:

Scenario 1:

I want to have 200,000 dollars when I am 65. To achieve this, at 30 years old, I set a savings goal. I then worked to achieve the goal for 35 years. I am now 65 years old, and my bank balance is 200,000 dollars. Yay for this incredible achievement! I now want to spend the 200,000 dollars I worked so hard to save.

But, uh-oh, when I go to spend it, everything is more expensive than it used to be. This is a result of inflation. Assuming inflation has risen 4% every year, inflation over the 35-year period has increased by 295%. This means that something will cost 3.95x what it would have 35 years prior, so my 200,000 dollars now has the spending power of only around 50,600 dollars.

*To calculate inflation, you use the following equation:

F = P / (1 + i)^n

F = Future cost P = Present cost i = Inflation Rate n = Years

F = 200,000 / (1 + 0.04 )^35

F = 200,000 / 2.81

F = 50,633

Scenario 2:

I want to have the value of 200,000 dollars when I am 65. To achieve this, at 30 years old, I set a savings goal of 790,000 (200,000 x 3.95 - same math as above, just the other direction). I then worked to achieve the goal for 35 years. I am now 65 years old, and my bank balance is 790,000 dollars.

I now want to spend the 790,000 dollars I worked so hard to save. When I go to spend it, everything is more expensive than it used to be. While I am surprised, I have prepared for this. So, even though I have 562,000 dollars, it has the spending power of 200,000 dollars.

Obviously, this feels a bit painful, but it is exactly what I planned for, and I have the value of 200,000 at my fingertips!

Yay for this incredible achievement!

While this may not be how you want to feel about your savings goals (that they need to be adjusted for spending power), I truly believe there is no power like preparation.

I don’t know about you, but I would so much rather have a crazy high number to reach that I know will allow me to have the value of 200,000 dollars, than to save just that and come to find in retirement that I can’t really afford not to work.

And of course, the examples above are to show the numbers you need when it comes to protecting against inflation. Yet, these equations assume that the money is sitting somewhere, earning no interest.

However, when invested in something like the stock market, we see returns on our money that can help us fight inflation (invested today: 73,976.22 compounded at 7% over 35 years is 790,000).

p.s. I am sure everyone has been on the edge of their seats, wanting to know why milk is referenced so often when discussing inflation. It is because milk has historically been, and continues to be, a household staple. As a result, changes in its price are immediately noticeable to families and individuals. Additionally, due to its continued demand, it is stocked and sold nationwide, so its price is easy to track over time.