"Inflation is the Income Investor's Biggest Enemy"
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Inflation is officially defined as an increase in the supply of money over and above any increase in the supply of goods and services.
If you're hungry, you have only $1 and there's only 1 apple in the world -- that apple will cost $1.
But if you have $2 and that apple is still the only thing you can buy, then it will cost $2.
I'm old enough to remember the 70s, when every time you went to the grocery store, the price of meat was higher. Every time you bought a 50 cent candy bar from a vending machine, it was smaller than the week before. (So the price stayed the same, but you got less candy for the same amount of money.)
Inflation Steals Your Spending Power
I remember waiting in line half an hour to pay $1.25 a gallon for gas in the first energy crisis of 1973 -- back when the minimum wage was under $2.
Chairman of the Federal Reserve Paul Volcker is generally credited with ending this problem by clamping down on the supply of money -- by raising interest rates. They peaked in the early 1980s at about 21%.
But while we've certainly reduced inflation rates in the past 30 years, we've certainly NOT ended it. It's been an unavoidable fact of economic and financial life since the end of World War II, when the developed economies went off the gold standard.
I'm not here to argue for gold -- but it's true that with no anchor to paper money, there's constant activity to increase the supply of it, over and above the increase in goods and services.
The Government Creates Inflation Through Its Economic Policies
You do it when you borrow money (you've created cash by trading your promise to pay the money in the future for a present good or service.) Businesses do it by borrowing money. Banks do it by loaning money.
Any financial advisor or writer with any ethics has to advise clients to pay off their personal debts. I do it in any article on this web site.
But the truth is, if EVERYBODY in the United States followed this advice . . . if everybody refused to borrow money except in extreme emergencies . . . if everybody refused to spend any more money on non-necessary items until they paid off all their credit cards, student loans and car notes . . .
Debt Creates Inflation But No Debt Slows Economic Growth
. . . if EVERYBODY did that, the U.S. economy would go into a deep recession if not a downright depression
If the government followed suit and refused to pay out money for anything but vital national security interests and to pay off the national debt . . .
There'd be riots and a national crisis that would make the 60s look like tame.
In the long run, we'd all be better off for doing this. We'd all have no more debts, personal or governmental, and as we paid off our debts and started buying things we wanted again (though not borrowing to do so), businesses would begin supplying these things again, we'd all get back to work and we would pay less in taxes and a lot less interest and therefore have all the more money to spend on fun things.
And prices would not increase, except in direct response to shifts in supply and demand (that is, an early freeze in Florida orange groves would still raise the price of orange juice), but overall price levels would not go up. There'd be no inflation.
As businesses continued to find technological and other ways to improve productivity, prices would gradually decrease.
Stopping Inflation is Painful
However, being human beings, nobody wants to go through the pain to reach the pleasure of living debt-free
So we put up with long term inflation and hope the Federal Reserve will keep it to a low level.
Yet Even a Low Inflation Rate Destroys a Fixed Income Investor's Purchasing Power . . . Over Time
If you put your money into a certificate of deposit that pays 3% a year, you pay 1% for taxes and the inflation rate is "only" 3% -- you've actually lost 1% of your purchasing power.
Now, the loss of the purchasing power of the money in the CD is not horrible. You should not be planning to actually purchase anything with it anyway. The purpose of that money is to make more money for you to live on.
Unfortunately, it will continue to pay you the same 3%, and the purchasing power of the interest you receive is reduced by inflation.
You get the same quarterly check from your bank, but now it won't buy as many groceries as it did last year.
How much the financial markets value money and interest from the short term to the long term is graphed by: The Yield Curve
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