With the US government pumping trillions of stimulus dollars into the economy and inflation rates ticking upward, some investors worry about inflation’s impact on their overall financial picture.

Let’s take a minute to understand what inflation is, how it may impact your finances, and what, if anything, you should do about it.

What is Inflation?

Like a balloon swelling larger and larger with big puffs of air, the prices of goods and services in the economy can become inflated as well. This may be great for the providers of these goods and services, but for most people it means they’re paying more for guns, butter, and Dr. Pepper.

A certain amount of inflation is good. Historically, US inflation has hovered around 2% per year, and it’s the reason your parents or grandparents may be heard to express in frustration “When I was your age a hamburger cost a nickel!”

The government watches inflation very closely and for good reason. An overinflated economy means the cost of goods and services have outpaced most Americans’ ability to afford them, hurting overall economic prosperity, and threatening economic recession or depression. That kind of inflation is worth worrying about, and should be avoided if possible.

How the Government Controls Inflation

Since the government wants to avoid rampant inflation, it uses certain financial measures at its disposal to do so. The big one is by controlling interest rates. There is a lot of detail about how that works which I won’t get into, but the basic idea is the federal government has control over certain key interest rates which other interest rates are based on.

During 2020’s surging pandemic, the government aggressively lowered its key interest rate to help boost economic development. Doing this reduces the cost of borrowing (think mortgages, car loans, business lending, etc), encourages borrowing, and stimulates the economy. If the economy gets overheated, raising interest rates can cool the economy down and ward off inflation.

No government tool is perfect, but that’s typically how these tools have been utilized in recent US history.

How Inflation May Impact Your Finances

If inflation is indeed on the horizon, which is questionable at this point, then the government may be forced to increase interest rates to cool the economy.

So what does this mean for your finances? Well, it’s kind of a mixed bag.

If you’re in the market to buy a new home, it might mean that your mortgage rate will be higher than it was in, say, 2020 compared to 2021. At the same time, however, higher interest rates may decrease home prices (or at least decrease their meteoric rise), improving affordability and construction costs.

If you invest in bonds, raising interest rates will hurt bond values (as interest rates increase, current bond values decrease); however, as your bonds mature you’ll be buying new bonds that pay higher rates of interest, increasing the amount of investor income received.

If you invest in stocks, raising interest rates signal a slowing of the economy, which hurts stock valuations, at least in the near-term. However, stocks are an excellent hedge against inflation over the long-term.

What to Do About Inflation

Inflation fears make investors do all sorts of crazy things:

Sell all their investments into cash
Sell all their investments into inflation hedging investments, like gold
Climb atop their house and howl at the full moon (Haven’t witnessed this myself, but I know a guy, who knows a guy…)

These are all pretty crazy behaviors. The last one needs no explanation (there is none), but the first two are worth addressing, since they’re the most common things I hear.

It’s not at all uncommon for investors to sell their stocks and bonds during times like these. Given the reasons above, many prefer to sit on the sidelines and “wait it out” until the economic picture turns brighter.

This is usually a mistake, since investors tend to get back into the market after it has already started its recovery, missing out on the important gains early on.

Some investors remain invested during periods of high inflation, but move to “safe” assets, like gold or other precious metals. I’ve explained before the downsides of gold as an investment overall.

The common mistake is that, while gold does tend to be a good hedge against periods of high inflation, stocks tend to be a much better hedge, which is ironic since stocks are the investments many folks tend to sell when inflation fears rise.

Not only is gold not the best protector against inflation, but moving all your investments into it means you essentially have all your eggs in one undiversified basket, which is never a good idea.

The best “solution” to inflation is to ensure that you have a reasonable investment plan in place. This means that if you have some investments earmarked for a near-term purchase, say two to three years out, they shouldn’t have been invested aggressively in stocks in the first place.

For investments earmarked for retirement, the market ups and downs that inflation can bring should largely be ignored, keeping a focus on the long-term growth potential of a well balanced portfolio.

Ditching a sound investment plan is turning a relatively short-term problem, like rising inflation, into a longer-term problem: sabotaging your financial goals.