The US economy is facing a serious challenge from rising inflation, which is eroding the purchasing power of consumers and squeezing their budgets. According to a recent analysis by Moody’s Analytics, the typical American household spent $709 more in July than they did two years ago to buy the same goods and services. This figure underscores the cumulative impact high inflation has had on consumer finances — even as price growth has cooled considerably in recent months.
What is driving inflation?
Inflation is the general increase in the prices of goods and services over time. It is measured by various indicators, such as the Consumer Price Index (CPI), which tracks the changes in the prices of a basket of items that represent the average consumption of a household. The CPI rose 3.2% in July from a year ago, down from 3.5% in June and 3.8% in May, which was the highest rate since 1982.
There are many factors that contribute to inflation, but some of the main ones are:
- Supply chain disruptions: The Covid-19 pandemic and the Russian war have disrupted the production and distribution of many goods, creating shortages and bottlenecks that drive up prices. For example, the global semiconductor chip shortage has affected the supply of cars, computers, smartphones, and other electronics, leading to higher prices and longer wait times for consumers.
- Rising demand: As the economy reopens and people resume their normal activities, there is a surge in demand for goods and services that were restricted or unavailable during the lockdowns. This creates a mismatch between supply and demand, pushing prices higher. For example, airfares, hotel rates, car rentals, and restaurant prices have all increased significantly as people travel and dine out more.
- Higher energy costs: The price of oil has risen sharply in the past year, partly due to the OPEC+ cartel’s decision to limit production and partly due to geopolitical tensions in the Middle East and elsewhere. This has translated into higher gasoline prices for drivers, as well as higher costs for businesses that use energy-intensive inputs or transportation.
- Base effects: Inflation is calculated by comparing the current prices with those of a year ago. Since the prices of many goods and services collapsed during the pandemic, the comparison with a low base makes the current inflation rate look higher than it otherwise would. This effect will fade over time as the base normalizes.
How is inflation affecting consumers?
Inflation affects consumers in various ways, depending on their income level, spending habits, and saving goals. Some of the effects are:
- Reduced purchasing power: Inflation means that consumers can buy less with their money than before. This reduces their real income and living standards. For example, if inflation is 3%, a consumer who earns $50,000 a year will have to spend $1,500 more to maintain their lifestyle.
- Higher borrowing costs: Inflation can lead to higher interest rates, as lenders demand higher returns to lend money. This makes borrowing more expensive for consumers who want to buy a house, a car, or other big-ticket items. It also increases their debt payments if they have variable-rate loans or credit cards.
- Lower savings returns: Inflation can erode the value of savings over time, as the money loses its purchasing power. This makes saving less attractive for consumers who want to build wealth or prepare for retirement. It also reduces the real returns on investments that have fixed interest rates, such as bonds or certificates of deposit.
- Changed spending patterns: Inflation can change the spending patterns of consumers, as they adjust their budgets to cope with higher prices. Some consumers may cut back on discretionary spending, such as entertainment or travel, while others may switch to cheaper alternatives or substitutes for more expensive items. For example, some drivers may opt for public transportation or carpooling instead of driving their own cars.
What can consumers do to cope with inflation?
Consumers can take some steps to mitigate the effects of inflation on their finances and lifestyles. Some of these steps are:
- Track your expenses: Consumers should keep track of their spending and income, and review their budgets regularly. This can help them identify where they can save money or reduce unnecessary spending. They can also compare prices and shop around for better deals or discounts on goods and services they need or want.
- Pay off high-interest debt: Consumers should pay off any debt that has high interest rates, such as credit cards or payday loans. This can help them save money on interest payments and avoid getting into a debt spiral. They can also avoid taking on new debt unless it is absolutely necessary or beneficial.
- Save more and invest wisely: Consumers should save more money for emergencies or long-term goals, such as buying a house or retiring comfortably. They can also invest their money in assets that can provide higher returns or hedge against inflation, such as stocks, real estate, gold, or cryptocurrencies. However, they should be aware of the risks and costs involved in these investments, and seek professional advice if needed.
- Seek higher income: Consumers should look for ways to increase their income, such as asking for a raise, finding a better-paying job, starting a side hustle, or acquiring new skills. This can help them boost their earning potential and keep up with inflation.