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Inflation is the increase in the prices of goods and services across an economy. When prices inflate, you need more money to buy the same things. The opposite of inflation is deflation, when prices become lower across a range of goods and services. Inflation is an important concept for investors to understand because it eats into your returns on your investments.

The Inflation Rate Defined

To measure the inflation rate, you can't just take a single good and measure how its price changes. You have to look at what's called a "basket" of goods and services. In the U.S., inflation rates come from the Consumer Price Index (CPI). The CPI takes what the government considers a representative basket of goods and services and records changes in their prices from month to month and year to year.

Historical Inflation Rates

While many countries have battled inflation and even hyperinflation in the past 120 years or so, the U.S. has largely avoided that fate. Average annual inflation in the U.S. between 1913 and 2019 was 3.10%.

If you look at a table containing the inflation rate from 1915 to 2019, you'll notice deflation (expressed as a negative inflation percentage) during the Great Depression. You'll also notice significant inflation in the '70s and early '80s. In general, though, the Federal Reserve moderates inflation to keep it around the 2% mark. In other words, you don't need to worry that you'll be carrying suitcases full of dollar bills to the grocery store any time soon.

One of the privileges of living in a developed country in this day and age is a certain amount of confidence that inflation rates will stay within a reasonable range. The inflation rate from 2017 to 2018 was just 2.44%.

How Inflation Impacts You

If your income stays the same while prices go up, you'll feel the effects of inflation. Your money won't stretch as far and you'll have to make some changes to your budget. In theory, salaries and wages should rise to keep up with inflation so that workers can maintain their standard of living. Social Security benefits, too, are subject to Cost of Living Adjustments (COLAs) that take rising prices into account.

If your income rises by the same percentage as the inflation rate, your purchasing power is not diminished. It doesn't grow or shrink. If your income rises by a percentage greater than the inflation rate, you'll be able to afford more goods and services. This is the scenario most of us want. It makes us feel better to see our purchasing power growing over time.

Of course, if your income shrinks or disappears, you might be in trouble. Other people who feel the negative effects of inflation are those on a fixed income, or those who hold fixed-income investments while inflation takes its toll on their purchasing power.

For example, if you buy a fixed-income security like a CD with a 2% yield and inflation rises to 4%, you're losing money. In an environment where interest rates are low, it can be tough to beat inflation without buying stocks. Bonds, CDs and savings accounts will keep your principal intact but won't necessarily grow enough to keep pace with inflation. That means you're less likely to meet your retirement savings goals. Fortunately, an inflation calculator can help you figure out a target for your retirement investments in future dollars.

Although stocks bring risk and volatility, they also have a track record of providing inflation-beating returns over time. Investing in stocks not only helps you grow your retirement savings, but it also helps your retirement savings last throughout your entire retirement. It's important to have enough retirement savings that you won't be up all night worrying about inflation.

Once you're retired and out of the workforce, if your retirement nest egg isn't growing, there's not much you can do to preserve your purchasing power if inflation hits. That's why our retirement calculator takes inflation into account when figuring out how much you should save for your golden years.