Government 
18
comments

What is Inflation? And Why Should You Care?

One of the topics that we have heard a lot about as the economy lurches slowly toward recovery is inflation. But what is inflation? We hear about all sorts of incarnations of inflation, from core inflation to stagflation. While getting into the nuts and bolts of inflation can be a complex exercise, some general knowledge about inflation can help you learn a little bit more about a very real force that can have a very real impact on your finances.

As you listen to monetary policymakers talk about inflation, and as you read about changes to the CPI, it helps to have a general idea about what is going on. That way, you will be prepared to make more informed decisions about what to do with your money.

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 Personal Finance 
17
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Inflation Doesn’t Tell The Entire Story

Here’s an interesting question – would you rather have $70,000 in 1900 or $70,000 now?

Those who are familiar with the idea of inflation are probably aware that $70,000 in 1900 is worth a lot more than $70,000 today. In fact, according to the BLS, $70,000 in 1913 (as far back as their calculator goes) is worth over $1.5 million today.

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 Investing 
18
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Why I Don’t Care About Inflation

In my post Growing Your Tax Refund much earlier in the year, an anonymous commenter noted that I didn’t account for inflation in my comparisons. I bring this up again (this has been brewing in the drafts for quite some time) because with the Federal Reserve opening the spigots with QE2, a lot of people are thinking about how inflation might be affecting them. In my post, I compared how your average tax refund could be increased based on what you did with the money (other than spending it).

An anonymous reader noted that I ignored inflation in my comparisons (it wasn’t relevant as I was comparing several options against one another), but in general I’m not terribly concerned with inflation. In fact, I can safely say that I honestly don’t care about inflation because:

  • I can’t control it.
  • It affects everything equally.


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 Personal Finance 
19
comments

Why Inflation Is Good For You

100 Trillion DollarsInflation is the invisible erosion of our money’s purchasing power. It doesn’t sound like it’s good for you, right? Economists have said for quite some time now that inflation is good for you, it’s good for the economy, and part of a healthy market. Yet when things are more expensive, I feel like it’s a bad thing and you probably do to.

This post won’t be about the esoteric economic benefits of inflation, you can read that in a textbook. This will be an explanation of the real and tangible effects of inflation on you, regular Joe or Jane Doe and your family.

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 Personal Finance 
38
comments

How to Protect Yourself From Inflation

Hot Air BalloonOne of the unintended, though predictable, consequences of the unprecedented rescue of the United States financial system is that there will be higher than average inflation figures for years to come. While it’s been popular to dispute the reported Consumer Price Index (CPI), the reality is that the marketplace doesn’t really listen to the reported stats. It reacts to reality. Your boss doesn’t walk into your office and say “Oh, CPI says I need to give you an x% raise this year to maintain your purchasing power.” and the grocery store doesn’t increase the price of a head of cabbage a few cents every month because the BLS came out with another report.

So we need to be proactive and be aware that inflation is a real concern, before it becomes front page fodder for newspapers.
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 Banking 
4
comments

Certificates of Deposit: Pros & Cons Weighed

Hiding Piggy BankFor the last ten years, certificates of deposit have gotten a terrible rap. Interest rates were low compared to the blockbuster returns of the stock market and you were locked into that CD for 12-, 24-, 60- months, all making it an unappealing investment option. For many, CDs only ever came up in financial conversation when you were talking about laddering an emergency fund because protecting your principal was your number one goal.

Well times have changed and CDs, with their FDIC insurance, have once again come into vogue as investors have plowed hundreds of billions of dollars into the CD market in recent weeks. I personally use CDs to help increase the rate of return on my savings, specifically in laddering my emergency fund, and below I will list three good reasons you should save with CDs and three reasons why you shouldn’t.

Three Good Reasons

Certificates of deposit are safe. They are FDIC insured up to $100,000 ($250,000 through December 2009) which makes the principal safe from loss. With the stock market as volatile as it has been the last several weeks, protection of principal is almost as important as appreciation. With the markets down double digits, earning what was once a “measly” 4% APY on a CD really looks good right now since it beats the market by a considerable margin! The best CD rates are now in the mid-4% APY range so they are at least competitive with other options.

As I mentioned earlier, the stock market is volatile and there’s certain comfort in knowing your money is safe and earning a little bit of interest. While I’m not worried about my retirement savings, as my retirement is forty years away, I would be hesitant to put any money I’d need in the next five or ten years into the stock market right now simply because it spikes and craters so easily. Would you be surprised if the market jumped 700 points? I’d be a little happy but the reality is that it might drop 700 points the next day, with seemingly no rhyme or reason. CDs? They just go up… slow and steady, but I hear that wins races.

Lastly, the rate of return isn’t bad. 4.65% APY, which was the highest CD rate as of this writing, is pretty good. It probably beats your bank’s savings account rate. If you have an online bank account, the best high yield savings account rates are pretty good too so they’re worth checking out as well. All in all, 4.65% APY isn’t 10%, the typical number used to talk about the stock market but I think you’d be hard pressed to make that argument given our environment.

Three Bad Reasons

Despite their relatively high, and safe, returns, inflation will eat your lunch. Inflation is going at a pretty good clip these days, 4.9% as of September CPI numbers, and it is the biggest problem you run into when you save with CDs. If you save at 4.65%, you’re losing 0.25% of your purchasing power each year and that’s before taking taxes into account. If you’re in the 25% tax bracket, 4.65% APY is really 3.49% APY, which means you’re losing 1.41% of your purchasing power each year. That being said, the alternatives aren’t too spectacular either.

With CDs, you’re locked into a set period of time. The shortest CDs are usually 6 months and offer the least amount of interest. The sweet spot right now appears to be the 12 month and 18 month CDs, though if you’re willing to lock it in for 60 months (5 years), you would be handsomely rewarded (in today’s terms). Fortunately with CDs, you’re totally locked in. You can often liquidate a CD if you surrender a number of months interest (often it’s 3 months, but it varies). That’s a nasty pill to swallow if you need your money though.

Finally, there are some better options if you are willing to put your money in a little bit of risk. Tax exempt money market funds are a good place to store money and get a much better rate of return. I recently looked at the Vanguard Tax Exempt Money Market and it had a tax equivalent yield of around 6% APY. It invests in municipal bonds to earn that higher interest but it’s not FDIC insured.

There you have it, three good reasons why you should and three reasons why you shouldn’t save using CDs right now. If you have any thoughts on them, maybe a point I missed, please share them in the comments.

(Photo: corrieb)


 Personal Finance 
2
comments

Mortgage Heatmaps, Roth 401(k)s & Repetition

I discovered this detailed real estate blog called Matrix and this incredible set of mortgage-related heatmaps used by Bernanke in his last speech. Heatmaps are the quickest way to get a “snapshot” of a situation and these go through so many permutations that you can get a really good sense of what’s going on (and there are so many maps!). I had no idea unemployment concentrations were dispersed the way they are and how badly hit the Michigan area has been lately given the major auto manufacturer’s financial woes.

My last employer recently offered a Roth 401(k), which is essentially a tax-free version of the tax-deferred 401(k), though employer contributions are tax-deferred. It’s an interesting concept that has been around for a few years but hasn’t been adopted too widely, probably because of the paperwork. If I had a choice, I’d split my contributions evenly between the two and give myself some diversification.

Trent has received numerous complaints that he writes about the same stuff over and over again and that it’s getting old. Unfortunately for all you excitement hounds, personal finance is repetitive, it is conceptually easy, and “slow and steady” does win the race. It’s the chase of excitement, having that fancy car so you can drive it fast, throwing some money at a high flying potential stock, or that huge flat panel television -I that’s the stuff that derails your trek to your personal finance goal. Spend less than you earn, contribute to your 401(k) and save for retirement, ensure you have proper and adequate insurance, blah blah blah – it’s repetitive but it works. Michael Jordan once said he shot a thousand free throws a day. How’s that for repetitive?

Nickel wrote a bit about his asset allocation this week and it’s something I am hoping to review sometime next week. I’ve input all the data I have into Vanguard’s Portfolio Watch and now I just have to figure out what my goals are so I can set things up correctly once and for all.

Housing doesn’t always go up. Sometimes it comes down. Hard. (scroll down to the story of the house that sold for $505k in 2006 and is now on the market for $177,495 – ouch)

Lastly, if you like heatmaps and those first dozen weren’t enough, here’s a cool one about all the pieces of inflation on the New York Times, my new BFF, courtesy of Consumerist (who got it from Nathan). Not surprisingly, that big red area is gas.

Have a great weekend!


 Government 
2
comments

Why Fed Rates Affect Inflation

When the Fed drops its federal funds rate, economists across the world shudder as they see the spectre of inflation peer over the horizon. You ever wonder why that is? The answer is quite simple but will come in two parts. First, a brief refresher on supply and demand, followed by how that and the Fed’s lowering of rates may bring on inflation. Before we begin, I want to make note that everything has been simplified from what’s actually going on. Everything is very complicated in reality but you can explain the gist fairly easily if you’re willing to take some liberties. Those who have a background in economics and know all the intricacies will see some inaccuracies, but they are there to make the explanation smoother. A basic understanding is far better than none at all.

Supply & Demand 101

Simplistically, economists believe that supply and demand will dictate price. If you have more supply with the same demand (surplus), the price goes down. If you have less supply with the same demand (scarcity), the price goes up. If demand goes up with the same supply, price goes up, and vice versa. You’ll see this represented with supply and demand “curves” with the price at where the two intersect. There’s far more to it than that but that’s enough to go on. (it’s actually quite cool if you’re interested, google up some more info)

Fed Target Rate

When mainstream media folks talk about the Fed lowering the federal funds rate, what they’re really talking about is the Fed lower its target rate. The Fed is like a puppet-master and the banks are its puppets. When the Fed says it wants to lower the target rate, it’s really saying that it’s going to be putting more money into the market to lower the cost of it. It’s like a puppetmaster putting on a good show, a twist of a finger here, a lift of the wrist there, and before you know it you have yourself a Broadway musical. The Fed’s “twist of a finger” is sending additional funds to banks that may be low on reserves.

Inflation!

Ideally, the target rate drives the Fed to only put as much additional funding as is needed to keep the economy humming along and banks able to fund their work. Unfortunately, there’s a lag between when the Fed begins acting and when the effects take hold. The fear of inflation is founded in the fact that if the rate is set too low and too much additional funding is pumped into the system, banks find themselves with more than they need.

What happens if they have more money than they need? They lend it out at cheaper prices! (more supply than demand) When consumers get more money, they will spend more money. When they spend more money, demand on goods and services will go up. As demand increases, sellers of products and providers of services will increase their rates… which is inflation.

Inflation is not bad. Moderate inflation is normal and expected. It’s a sign that goods and services are in demand, consumers are financially strong enough to support increased prices, and a signal that the economy is strong.

High inflation is bad. It’s bad because it hinders economic growth. When inflation is high, investors will demand higher rates of return for their savings and so borrowers of money, business and such, will have to pay more to borrow money. If they pay more, the pace of growth slows down. The economy slows down, inflation will settle, and we continue the cycle all over again.

That’s (simplistically) why the Fed lowering rates can lead to high inflation.


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