Inflation Is Set to Rise. Here's What That Means for Your Finances

Ahead of Federal Reserve Chairman Jerome Powell's speech at the virtual version of annual Jackson Hole conference in Wyoming, speculation on what lies in store for U.S. inflation is rife.

Since the coronavirus pandemic set in, central bankers have rolled out many of the tools in their arsenal—cutting interest rates, supporting liquidity—and for the moment inflation is relatively inactive. In the current state of the economy this can't last.

The Fed's balance sheet has rocketed to more than $7 trillion since march, and is up by around $3 trillion. It is now more than a third of US GDP and estimates put it close to $10 trillion by 2021.

Many in the market, both in the U.S. and elsewhere, are worried about the potential damage a change in inflation could cause.

"The market is grappling with the risks of both deflation and high inflation," Theo Chapsalis, head of U.K. rates strategy at NatWest Markets told the Financial Times. "I have never seen the investment community so divided."

The International Monetary Fund projects a 2.24 percent annual rise in the general level of prices in the U.S. until 2021, as shown in the graphic below provided by Statista. This means that a product bought today for about $100 will cost about $102.24 next year.

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Projected annual inflation rate United States Statista
Projected annual inflation rate in the United States 2010-2021 Statista

Inflation between 2-3 percent is considered to be normal, but central banks prefer to prevent it going too far either way.

The Fed is expected to use "average inflation" targeting as a way to bring the economy in line. This is a departure from previous policy strategies.

Specifying a rate as a goal and adjusting policy to achieve it focuses on price stability for consumers and keeps surprises to a minimum for businesses and financial markets.

"Inflation targeting would be a fairly hefty change from The Fed's previous outlook," Chris Beauchamp, chief market analyst at IG in London, told Newsweek.

"How they're going to achieve that is open to debate. It's an interesting step change from central banks. For consumers, we may see higher prices eventually, but we have to see inflation get there first."

Jerome Powell
Federal Reserve Chair Jerome Powell testifies before the House Financial Services Committee on Capitol Hill on June 30, 2020 in Washington, DC. Federal Reserve Chairman Powell and Treasury Secretary Steven Mnuchin testified on their agencies’ response to the coronavirus pandemic. Tasos Katopodis/Getty Images

What does inflation mean for your finances?

One of the common effects of inflation in the real economy is that it erodes buying power of consumers. As such, money that people have in the bank no longer buys as much as people expected it to.

Severe inflation is considered dangerous to a country's economy as it can rapidly diminish GDP. A response to this in real terms can lead to people buying products sooner, when they will get more bang for their buck, rather than later. Cash loses value, while some products don't.

For consumers, this would mean buying things like gas, food and clothes, while businesses would make capital investments and potentially decisions they might have otherwise put off until later.

Spending, however, can trigger more inflation, in turn creating a damaging feedback loop. As people spend, the economy is awash with cash and the supply of money outstrips demand. Currency buying-power falls at a fast rate.

While this scenario is not a good one, central bankers and economists also view a low rate of inflation as a problem. It can reflect a slow-moving economy and low standard of living as well as giving policy makers little room when crises hit, such as the coronavirus.

The Fed has previously signalled it will do everything it can to protect the economy as it is battered by the pandemic. Inflation is its next big hurdle.

Inflation Is Set to Rise. Here's What That Means for Your Finances | Business