Inflamation - The Good and the Bad
04/01/2010 - Typically when we hear the word "inflation," a chill runs down our spines. As investors, we know that inflation eats away at returns and diminishes our purchasing power. But a modest, expected rise in the costs of goods and services isn't all bad. When inflation begins to rise, it can be a sign that the economy is improving.
Right now, we are in a very low inflationary environment. Labor Department figures for the first month of 2010 show that the Consumer Price Index (CPI) increased just 0.2 percent, led by higher fuel prices. But if you exclude energy and food, the CPI's core index actually dropped 0.1 percent, a reflection of lower prices on things like new cars, clothing and shelter.
So how does inflation affect your ability to earn, spend, invest and save? The following areas are important to watch:
People tend to complain about prices going up, but they often overlook the fact that their wages typically rise to keep pace. In a zero inflation environment, you might be less likely to get a raise than you would when inflation is rising. For those collecting Social Security, a cost of living adjustment is pegged to the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which is a measure of inflation. When inflation is absent, there is no cost of living increase.
Low inflation and low interest rates often go hand-in-hand. So, while the cost of living may remain steady, you might find it difficult to earn significant interest on cash you have in savings. This can be especially problematic if you're relying on fixed income. In that scenario, even if you withdraw from your accounts at a steady rate, your account balances will decrease at a faster pace because you're earning less interest income than in the past.
Your investments should always be viewed with inflation in mind. It's the real rate of return which determines whether your wealth is increasing. For example, if inflation is at five percent while your investments are earning only three percent, you are effectively losing two percent on those investments.
Anyone with fixed debt payments like many mortgages or student loans can benefit from rising inflation, because incomes tend to increase while the debt payments remain the same. However, those with variable rates, like credit cards or adjustable-rate mortgages, will likely see their monthly payments rise as interest rates rise in an inflationary environment.
Inflation impacts your tax bill. Normally, tax brackets are indexed to inflation. When inflation rises, many tax breaks follow — but most won't increase this year. In 2010, the majority of taxpayers who don't itemize will get the same standard deduction they took in 2009 — $5,700 for individuals and $11,400 for married couples filing jointly. The personal exemption for every taxpayer, spouse and dependent will remain at $3,650.
If you're concerned about safeguarding your portfolio against some of the negative effects of rising inflation, there are a few options you might consider, including: investing in Treasury Inflation Protected Securities, the values of which change with the Consumer Price Index; stocks, which have historically provided a good hedge against inflation; and hard assets like commodities.
Consider speaking to a financial advisor about which investments might be appropriate for you.
This column is for informational purposes only. The information may not be suitable for every situation and should not be relied on without the advice of your tax, legal and/or financial advisors. Neither Ameriprise Financial nor its financial advisors provide tax or legal advice. Consult with qualified tax and legal advisors about your tax and legal situation. This column was prepared by Ameriprise Financial.
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