We’ve all heard of inflation. Some of us have even heard of high inflation, low inflation, deflation, hyper-inflation, etc.

I know the more these kinds of terms are thrown around, the more your eyes will gloss over. But we need to know how inflation impacts us. The rate of inflation is an important gauge to help you gain a sense of whether the value of your money is growing, remaining constant, or even diminishing over time. With that info, you can decide how to manage your money.

What is inflation?

Inflation is defined as the cost of goods and services over time. It represents the diminishing purchasing power of a dollar over time.

An example: In 1980, a gallon of milk was about $1.65. Today, you can pay about $3.50 for that same gallon.

Why? What happened?

There are number of factors that impact the rate of inflation. However, the primary drivers are the demand for good & services and the supply of money.

To figure out why prices have gone up, we need to break our normal thought process and consider how an item reached the shelf (be honest, you normally don’t think about that). We will use bread as an example:

Bread is made from flour. Flour comes from grain. Grain comes from wheat. Wheat is a crop that is grown here in the U.S. and all over the world.

The process of converting wheat into bread on the grocery shelf has several channels, especially if that wheat is grown overseas. With each of these channels and conversions comes cost, which is priced into the final product.

Also consider the ever-rising cost of oil. Consider the explosion in our population numbers. You can even consider the amount of money that was destroyed in our most recent global economic downturn. (It was pretty substantial!)

Increases in production and transportation costs, increases in the demand (more mouths to feed) without a proportionate increase in supply, and even climate changes, have caused the price of your Wonderbread to jump. Climate? Yes. We’ve experience adverse climates which impact wheat crops. It’s actually happening in Russia right now.

The cost of goods can naturally go up for numerous reasons, as we’ve shown. But, here’s what’s crazy: the cost of services has increased more than the cost of goods over a number of decades.

OK, what about money supply?

The supply of money in our country is a delicate and very difficult balance. Issuing money isn’t that easy and isn’t always wise. If you increase the supply of money, it may only diminish the purchasing power of your dollar, thus, increasing inflation (because less goods can be purchased with the dollar).

And if you restrict the supply of money too much? The dollar may be valued too high, thus too many goods can be consumed. And, an overly strong dollar may impact foreign trade. Like I said, it’s a delicate balance.

The point?

I give you this context to make the point that you should really be careful and watch where you hold your money. More specifically, watch how much money you hold in cash. Why?

1. Interest rates are low. We’ll go in-depth on this next time.

2. History has shown us that there has not been a liquid savings option (think money market, CDs, checking or savings accounts) that has outpaced inflation on an after-tax basis.

This means holding excess liquidity is highly inefficient. You can’t beat inflation.

Knowing that, you have to ask yourself, why maintain liquidity?

Emergency/Reserve Fund: For single income households, maintain 6 months of income. For joint income households (assuming there is not a large disparity between the spouses or partners income), maintain 3 months of income. During this downturn, with high unemployment, it does make sense to lean on the more conservative end of the spectrum and hold a bit more cash. But not too much more.

Short-term goals: Maintain liquidity for any short-term goals that require capital (e.g., home down payment, auto purchase, eliminating high-interest debt). Think short term as a 1-to-3-year window.

Other than that, there really is no need to maintain liquid capital. I know this may sounds unsettling, but unless your money serves a more immediate purpose, it is highly inefficient to hold cash.

We have talked about a few alternatives in the past. But to determine how your cash flow should best be allocated, you may want to consider consulting a financial professional if you’re not 100% confident with your present strategy.

Just remember the above words about inflation. It is the silent gauge that measures the destruction of your hard earned dollars.

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   Inflation Motivational Poster
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   Do Yourself A Favor: Pay Attention To Interest Rates
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