Budgeting in a time of inflation

By Philip Brewer on 23 April 2008 (Updated 23 February 2010) 27 comments
Photo: Philip Brewer

My very first experience running a household was in 1980, just as the last big inflation was spiking up over 10%.  My carefully constructed budget was completely destroyed by prices that were rising by 1% every month.  Since then, I've given considerable thought to how to deal with just that situation.  Since history seems dangerously close to repeating itself, it's a timely topic.

For a long time, after the inflation of the early 1980s was brought down, and until just a few years ago, inflation was low enough that you could just about ignore it.  There's a certain kind of luxury in stable prices--you know what things are going to cost.  I could go to the store with exact change in my pocket, meaning to buy a 39¢ cookie.  During a time of inflation, that doesn't work.  Today, that cookie might cost 49¢.  Or maybe they don't even make that kind of cookie any more, having replaced it with a slightly larger one that costs 99¢.

Contingency plan

The number one tool for dealing with inflation is to have a contingency plan in your budget.  One of my first posts for Wise Bread (Plan for expensive fuel, written in July last year) emphasized the need for contingency planning in your budget.

You can think of your contingency plan either in money terms (a stream of dollars that are available to be re-directed in case of unforeseen expenses) or in lifestyle terms (certain categories of spending where you can cut if necessary), but it's really the same thing--a subset of your money is budgeted one way during good times, with a plan for redirecting it in bad times.

Contingency plans are great to have when times turn tough.  The process of creating them is also useful for motivating yourself do things like boost your emergency fund, cut unnecessary spending now (rather than when forced to by circumstances), and to investigate ways to diversify your income stream.  

It's never too late to start creating some contingency plans in your budget.

Inflate your budget

The second tool for dealing with inflation--especially after an inflationary period has already started--is to explicitly allow for it in your budget.

To the extent that the problem is inflation, then all you're really facing is a timing mismatch: Your expenses rise every week, but your income is probably fixed for a year at a time.  Your budget can deal with that problem with a little paperwork.  

First, estimate what the inflation rate is likely to be for the next year.  Ideally, use figures from your own expenses--your own personal inflation rate will be different from the national average.

If you don't have the data to generate your own cost-of-living index, the Bureau of Labor Statistics publishes several.  The Consumer Price Index, has gone up 4.0% in the last twelve months, but I think the hedonic adjustments made to that index are causing it to understate the price changes that ordinary people--especially ordinary frugal people--are seeing.  They also publish a Produce Price Index, which has a lot less of that sort of adjustment.  The PPI for finished goods has gone up 6.9% in the past twelve months.  That roughly matches the inflation rate that I'm seeing.  (If you want to be horrified, the index for "crude goods"--basically commodities like crude oil, coal, cattle, corn, etc.--is up an eye-popping 31.4% in the last twelve months.)

Whatever value you think is the best estimate for inflation over the next few months, apply that inflation rate to your budget categories.

For things like groceries, where the price can change at any time, apply a fractional adjustment to each month.  Here's a grocery budget that's been inflated by 6.9% (applied as 0.58% per month):

  May June July August
Groceries $400 $402 $405 $407

For things like your rent, apply the adjustment in the month that your lease expires.  Here's a rent budget that's been inflated by 6.9%, assuming that the new lease takes effect in August:

  May June July August
Rent $600 $600 $600 $641

Remember, of course, that these are just estimates.  When you get a new lease, replace your estimate with the actual rent for the next year.

Finally, align your budget so that your actual income covers your inflated expenses.  If you can expect a raise at some particular date in the future, run your budget out to that date.  When that date arrives and you learn what your income for the next year is likely to be, repeat the process to make a budget for the next year.

More than just inflation

It is critically important that you understand that not all price changes are inflation.

Inflation is the money becoming less valuable.  It shows up as higher prices, but it's not the only source of higher prices.

To the extent that what we're seeing right now is inflation, the process of just adjusting the numbers in your budget can handle it, because you can reasonably expect that your raise will balance out the inflation--your standard of living will stay about the same, just the dollar amounts will change.

Sometimes, though, higher prices mean something else:  They mean that we're becoming less wealthy.  If that's what's happening (and I think, to some extent, it is--especially in the areas of fuel costs), then you can't expect incomes to rise enough to maintain standards of living.

To the extent that what we're seeing is not inflation, but rather a drop in standards of living--in particular, if your own income doesn't rise enough to match the rise in prices--then you need to make that adjustment in your budget.  Either find ways to increase your income, or else find ways to cut your expense.  Small changes you can make right away.  Bigger changes take more lead time.  

That's why it's worth going to all this effort--looking out a year gives you a sense of whether you need to start making those bigger changes.

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gtWise

Inflation is just redistribution of wealth. The above article accounted for 2 scenarios. When you get an amount of raise equal to inflation and when you don't get a raise and you become poorer. However for every case of someone not getting a raise equal to inflation there is someone who gets more than that.

My wife and I got 8% raises this year respectively which I assume is above inflation rates. We also got 10% raises the year before.

Inflation is just a tool to redistribute wealth and that is all there is to it. People who start to swallow the increase in prices are the ones who get shafted on the deal and the ones who raised the prices in the first place reap the benefits. Sure you need to account for increases is price but as long as you're on the better end of the inflation stick you've got nothing to worry about other than using larger numbers in your budget.

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luky u

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gtWise

For people who bought reasonable houses with fixed terms and interest and have other long term fixed debt obligations are making out like bandits in high inflation periods since a large portion of their expenses are already fixed. I personally would weclome high inflation with matching compensation vs. no inflation. That would make my house payment relatively smaller as time goes on.

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Guest

Well said.
I must say, anyone who welcomes inflation is both arrogant and ignorant. Perhaps your income will stay ahead of inflation, now, but unless you're a corporate mogul, it won't stay that way.
Have a nice mortgage? Maintainance costs (including utilities) are going through the roof.
Devalued money wil devalue your savings/retirement funds
Devalued money increases costs across the board, and even if it doesn't appear to affect you personally, check and see what it is doing to your city/county/state/federal services. ....That pothole could go another year before being fixed.
Want to trade up on a vehicle? You're not going to get as much even IF you can get financing.
Worse case scenario is not only will everything cost more (even accounting for inflation), many things will simply not exist. Food shortages are already occuring within the US, gas rationing could happen at any moment, police and fire services are being limited and in cities going bankrupt, could become nonexistent. This isn't an apopcalyptic view, but reality. Do some research.

Philip Brewer's picture

Modest inflation seems nice--that's why policy makers like it so much.  It heats the economy up, producing jobs and prompting additional investment.  Unfortunately, that extra activity is based on an illusion.  Eventually, reality catches up.  Some of that investment turns out to be uneconomic--business that overexpanded need to retrench; some even go bankrupt.

If you knew when inflation was going to heat up and when it was going to cool down, it would be easy to profit:  borrow long-term at low rates when inflation is low, invest in assets of enduring value, then pay the loan off with cheaper dollars.  But nobody knows what future inflation is going to be.  It's easy enough to preduct 6 to 8 months out (right now, for example, inflation is going higher), but beyond that, it could go either way.  It's entirely possible that a sharp downturn in inflation could make even a very low-rate loan feel expensive.  It's also possible that the "things of enduring value" don't endure as well as you might expect--look at home prices, for example.

As gtWise says, there are winners and losers in inflation.  It's easy to congratulate yourself too early, though, if you think you're making out well when inflation just starts to heat up.  That's exactly when it seems nicest.  The rest of the cycle doesn't tend to feel so good.

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Curt

The problem with inflation is that it can sneak up on you, especially when the government is fudging the numbers. Some economist say that the actual inflation is more like 10-12% already and that the CPI calculated has been wrong - since they changed it.

HYPERINFLATION AS EARLY AS 2010

http://www.learcapital.com/qry/backgroundstories.taf?_function=detail&NE...

Nixon created price controls and wage freezes in 1971 when inflation was only 4.9%. I think a lot of people are underestimating the power of inflation that we are going to see in the next few years.

The coming wave of inflation will change personal finance strategies. Adjusting your budget will not work. Using your saving or investments (based in dollars) will not work because they will be dwindling in purchasing power.

Frugalness is no longer going to be a safe place. Cash management will become a much higher priority - and will consume much more time to protect your wealth. Businesses will change, as they reduce production and sales while adding accountants. Low margin and free products are toast.

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gtWise

@Guest,
Perhaps your income will stay ahead of inflation, now, but unless you're a corporate mogul, it won't stay that way.

How can you say that? If you're a private business you can keep charging more as long as the market will bear it. And when you can't charge more for your goods/services that is when basically you have reached the equilibbrium point and you either have to stop making your widgets if it no longer makes financial sense and find something else or face the recession that is coming out of it.

If you're working in a fixed wage postion that requires no training or experience and people are a dime a dozen who can do your job then you might be in trouble. You might experience a pay cut. But all it means is that you were overpaid in the first place and you finally get your well deserved adjustment.

A friend of mine who's in law school right now got a job offer and accepted the job last year and did an internship last summer. He's in his last year of school and already got a 30% raise before even starting the job. He didn't demand it, the market demanded it. It's supply and demand. Easy as that!

Have a nice mortgage? Maintainance costs (including utilities) are going through the roof.

I guess I don't get your point. Let's say you make $60,000 a year. Your mortage payment is $500 a month and your maintenace cost is $100 a month. That means your monthly mortgage is 10% of your income and your maintenace cost is 2% of your income and you are left with 88$ for everything else. Now you get 10% inflation and you get a 10% raise. Your monthly gross salary is $5,500, your mortgage is still $500 and your maintenace cost jumped to $110. You're still paying 2% for maintenance but only 9% for mortage leaving you with 89% for everything else.

Devalued money wil devalue your savings/retirement funds

When inflation is high, interest rates are high too. You make more money on your investment because of it. If you put your money into companies that don't follow the inflation then you're jsut back to the whole basic premise of inflation: redistribution of money. You better get out of those companies that are eating the cost of inflation.

check and see what it is doing to your city/county/state/federal services

Funny you should mention the government. They're the ones who benefit from high inflation the most. They issued a ton of bonds with low interest and get to repay them with cheap, freshly printed money. Unless your government runs on surplus budget they're making money on inflation.

Food shortages are already occuring within the US, gas rationing could happen at any moment, police and fire services are being limited and in cities going bankrupt, could become nonexistent.

Yeah and the world is about to end tomorrow. Doomsdayers are all over the place and planting fear is the current job of the media, as that's what sells you stuff. Credit protection against ID theft, terrorism insurance.....Whatever.....

There are definetely losers in inflation. Retired people, people on fixed income and people with overvalued jobs. They will all be hurting in high inflation. Call me arrogant, luckily I'm not one of these people.

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Guest

retired people, people on fixed incomes and people with "overvalued jobs" are a large portion of the US. Someone making $9.00 barely able to pay rent and buy gas and food gets a pay cut or is replaced by someone willing to do the job for less because they need anything they can get, and you say we're doomsdayers. And what happens when everything goes up but your income, because your company didn't make a profit this year. Then you're stuck with an increase in the cost of living, including utilities, food, fuel, but no increase in income. Inflation doesn't always work out as pretty as it's says it will in your economics book.
I'm glad you and your friends have cushy jobs that allow you to pretend everything's just fine. The rest of us are going to try and find ways to put gas in our cars and food on our tables.

Philip Brewer's picture

@Curt:

I actually think hyperinflation is not the most likely scenario.

I base that on three things:

  1. The people hit hardest by inflation are people with money (because the money is becoming less valuable).  People with money (as a group) are powerful enough in this country to significantly influence government policy.
  2. We know how to stop inflation.  As recently as the early 1980s there was considerable disagreement about that--some people thought controlling deficits was crucial, others thought it was controlling the growth in the money supply.  After Volker's success at the Fed, we now know that the money supply is what matters and that you can bring down inflation even while running huge deficits.
  3. Long-term interest rates are still quite low.  That suggests to me that large numbers of people with large amounts of money strongly believe that the dollar will still be worth a large fraction of its current value as far out as 30 year from now.

Hyperinflation is a danger.  I just don't think it's the biggest danger.

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I'm nervous with the state of our economy, but I'm not in panic mode. As long as you spend less than what you make and budget accordingly, you should not feel a big negative effect from inflation.

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Guest

I found your article helpful. It seems most of the commentators aren't in the trenches so to speak, so they can deal with all this stuff on an intellectual basis. But when you go to the store and have $68 to feed your family for the week, and there is no more to be had, feeding your kids dandilion greens starts looking like a viable option.

Philip Brewer's picture

Wild foods are certainly not a crazy idea.  Neither are gardening, bartering with neighbors, or a dozen other strategies for avoiding the money economy--because inflation only exists in the money economy.

I've written a bit about that here:

http://www.wisebread.com/opting-out-of-the-money-economy

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Guest

i meant luky u to the arrogant a%&*()), not you Philip

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Curt

@Philip

Even if we escape hyperinflation, by drastically raising the interest rates as Volker did, it still took years to get inflation under control. Nixon started price controls when inflation was 4.7% and inflation still increased to 13.3% when it peaked in 1979. Therefore, if we are at 8% inflation today, then we may see 25% inflation by 2015 - which is enough to cause drastic changes in our economy.

In regards to your three reasons why we will not see hyperinflation:

1) You are partly correct. The people with the most money have the most to money to lose - but the rich will preserve their wealth by moving it to other currencies or commodities or foreign investments - while the poor and middle class will get wiped out.

2) Inflation can be stopped by reducing the money supply, but the current monetary policy of our government is doing the exact opposite.

3) Long-term interest rates are only low right now because everyone is afraid of the stock market and has moved their money to US treasures. But, that will be changing very quickly once the government realized just how large the inflation problem is and begina to change the current monetary policy. But, even if they don't, foreign investors are losing patience with the falling dollar and are on the verge to selling all dollar based assets - which would trigger a large increase in long term interest rates. Now is a good time to get a 30-year fixed mortgage. Either way, long-term interest rates will be going a lot higher in the next few years.

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AndyS

Great post and I agree you need to adjust ones budget for inflation. I recently wrote a post on the rising cost of my grocery bill thanks to inflation. Unfortunately I think the future is pretty bleak and we need to expect many more increases. If only our wages would keep with up inflation.

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gtWise

people with "overvalued jobs" are a large portion of the US.

Maybe that is the root cause of the problem. Maybe the unionized workers who earn more than what they produce is the problem. Maybe people who have a sense of entitlement to cheap gas and cheap food are the problem. Maybe these people living on the edge living up the future on credit and can't make a differentiation between wants and needs is the problem. Maybe it's the media feeding us with the latest must have product advertisements is the problem. Maybe it's the thousands of people who think they need to yak on their cellphone in their cars to and from work is the problem, because a cellphone is an absolute neccessity in today's world, NOT!. I don't know.....

I'm glad you and your friends have cushy jobs that allow you to pretend everything's just fine.

Who said I had a cushy job? I said I had a job where I get paid what I deserve and right now I deserve 8% more than last year. That is all I said. I also said that I am confident that with my qualification and profession I will have no problem finding a job that will pay me enough to keep up with the rate of inflation, whatever that might be.

Shutting off the tap of cheap money will hurt people who deserve to be hurt because they were getting something for nothing in the first place and freeloaded on our society.

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Guest

@gtWise:
so.......teachers, firefighters, police are overvalued? Most will argue they are chronically underpaid/overworked and do their jobs because they love what they do, and gasp, care about others. These groups are being hard hit by rising costs and many are losing their jobs. Supply and demand has nothing to do with it.
Hope you never need one of them.

It's also amazing how you KNOW so much about everyone in the United States, about their habits, their work, their lives such that you can make sweeping judgements; that you are entitled to be paid what you think you deserve, but others are not.

Phillip-don't know you, but always enjoy your posts- sorry this has gotten rather skewed, but sheesh!

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Guest

Yes, teachers are grossly overpaid. Their starting salaries here are more than 10% above the average wage-earner -- and that's for a 9-month job. Don't group them with firemen and policemen who put their lives on the line.

btw, we are entering DEFLATION rather than inflation for 2009. Prices will plummet. Sell now, buy in 6 months.

Philip Brewer's picture

Thanks for the good comments and the kind words.

All I want to add to the above is a general warning not to be taken in by the attractive side of early inflation. 

It is the nature of inflation that it fools everyone about what true values actually are.  That's the main way it does its harm.  Many people will be behind the curve.  Some people will be ahead of the curve.  Some, due to some combination of cleverness and luck, will be right on the money--but so many of their counterparts will be wrong, that there's only a limited benefit in being right.

Money ought to be a yardstick for value.  During inflation, that yardstick can't be relied upon.  It's as if the government started scattering yardsticks of all different sizes.  You might make a deal that seemed good, only to find that the yardstick used to measure what you got was shorter than you expected.  Or, you might make a great deal, only to have the guy you're trading with suddenly go broke, because he'd been using yardstick that was too long.

The other really bad thing that inflation does is force people into short-term thinking.  Essentially as it is to plan ahead as far as your next raise (because you have to allow for price changes that will occur between now and then), looking out beyond that becomes very difficult.  Don't give up on making long-term plans, but be sure to allow for the fact that inflation adds a whole additional layer of uncertanty.

Good luck!

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gtWise

so.......teachers, firefighters, police are overvalued? Most will argue they are chronically underpaid/overworked and do their jobs because they love what they do, and gasp, care about others. These groups are being hard hit by rising costs and many are losing their jobs. Supply and demand has nothing to do with it.

Supply and demand has everything to do with it!

Funny you should mention these guys/gals. I am actually a Certified Firefighter and an NREMT Certified First Responder. I'm also an active volunteer firefighter/first responder in my community. I do this for free. I went through all the training and certification just to be able to serve my community. Last year I responded to over 200 emergency calls out of my own free time for no compensation other than the knowledge that I get to help people in distress. This year I'm up to 100 calls so far.....

I love how you bundle the two statements of "chronically underpaid" and "because they love what they do" in one sentence. You're almost implying that these professions should be paid more because they love what they do. That is not how economics works.

I'm not sure how it is in your part of the country but over here there is a huge surplus of firefighters or people who'd like to be firefighters. At the closest large city fire department over 10,000 people will test for 100 spots. 10,000 people are willing to get "chronically underpaid" yet only 100 will get in. Seems to me they're not underpaid enough when supply and demand are so out of propotion. Who knows, with such a specialized field as firefighting you do want a 1:100 hiring ratio and the compensation is just right although I might venture to think otherwise.

But I do know that my department's paid guys just got a huge raise this year due to going 24/7 from part time (I'm talking 80% raise) and I think the raise was unjust. And I, as a taxpayer, am paying for it in increased taxes (our local city tax just doubled from the year before). They were all complaining about low pay before the raise, yet I did not see one of them quit because of it. However I did see fresh cadets out of the academy lining up outside the door waiting for a spot to open so they could get in and get "chronically underpaid".

So please, don't lecture me about how severely underpaid these people are when there are 100 people are waiting outside for a spot to open and they'd be more than happy to fill it.

I think you have just proved my point about people having this sense of entitlement in our country. Remember what the constitution says: a right to pursue happines, not a right to hapiness. There is a HUGE difference between the two.

Phillip-don't know you, but always enjoy your posts- sorry this has gotten rather skewed, but sheesh!

This post is not skewed now, the original one was. It basically said that inflation is bad and everyone gets screwed on it. Which is simply not true. I have tried to point out that there are people and government municipalities who will make out like bandits during a high inflation period and people who have decent, not overpaid jobs should not have much to worry about. Too bad that apparently these people are not the target market for this blog, it's people with money problems to start with sitting in overpaid jobs.....

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Obviously it is impossible to avoid inflation. It exists all the time. It is one of things that we can never really get rid. That is the nature of economy. So how do you really prepare for inflation. Be prepared. If your financial house is in order it will already account for inflation, that includes all your budgeting, emergency funds, investment accounts and so in. Be smart and get your financial hose in Order and you should be able to avoid the common problems if you weren't.
http://financialzip.com

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Greg

I am a realtor and I have seen some ups and downs I feel though that we are at the bottom. greg moser

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Guest

gtWise is correct that inflation just redistributes wealth. In the long run however it is disastrous to the economy. Why bother doing anything productive in the economy if you can make money by buying hard assets and watch their value rise!

Real wealth is created by having a large differential between income and costs. Having a good income and being frugal helps in this respect.

One myth that needs to be dispelled is the thought that moderate inflation is normal. The mild inflation of the last 60 years is in fact an anomaly. If you look far back in history in the era of hard money you will see hardly any inflation. The whole century before WWII saw large increases in wealth without any inflation at all. Inflation rather comes around when governments are allowed to print money at will.

If say you look at Japan over the last 15 years, the average Japanese person has had their standards of living increased. Although incomes have stagnated, the cost of housing, rent, goods etc have fallen. Likewise if you look at the industrial revolution the prices of goods declined substantially due to increased productivity.

I remember seeing an article explaining the real wages of Americans has not advanced significantly for the last 30 years. I'm not trying to pick on the US. This is a problem with the western world. I would suggest that the mild inflation since WWII has had a distortionary effect on the western economies. Rather than focusing on productivity improvements there has been a tendency to gamble on real estate and stocks and buy consumer goods with more and more debt.

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Guest

Inflation via money supply increase is a government "scam" of sorts. The person who said the government makes out in inflation is absolutely correct. I am wondering if the current policies are intended as a way to inflate away some of our huge national debt and reduce future obligations like social security (which, recall is tied to CPI, not true inflation).

On a more personal level, I am a retiree (former professional) living on income from a combination of fixed assets from a DB pension and variable ones from a portfolio. I planned for 4% long term inflation, but the current situation has me bit worried as it exceeds even my "worst case" secenarios.

The person who said high interest rates come with high inflation is wrong, wrong, wrong. Right now there is a huge disparity between the two. In the late-70's - early 80's, the interest rates were high, but negative in relation to inflation until Paul Volker had the balls to fix the problem and threw us into severe recession. Back then, having low-interest leverage like mortgage debt or tangibles like art was the way to get by. Now real estate is an albatross.

I'm afraid that we must face the music at some point and have a real recession (not the current whimpy one) or we'll never get back on track. I wonder if the "high raise" commenter will do as well then. And please, don't tell me you are a lawyer and deserve your raises. Lawyers are parasites who produce NOTHING, and deserve about as much.

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Guest

That's pretty cool discussion. I would like to digress a bit and would like to know about how to benefit from recession? Is buying fixed assets a good idea when property prices are going down?

Philip Brewer's picture

Just being concerned about whether prices are going down is a pretty good indicate that you shouldn't be buying.  The only time it makes sense to buy during a recession is when you don't care which way the price will go next, because you're buying something that you want or need, and you can comfortably afford it at the current price.

During a recession, valuable stuff of all sorts will be available for less than its real value--but will very likely be available even cheaper later.  Don't buy it if your goal is to sell it later, after the price goes up--there's no way to know when that will be.

On the other hand, during a recession you can often buy stuff at low prices--often below replacement cost.  That's great if you buy stuff that you want or need.  Just don't buy it planning to sell it at a profit, and don't buy it with borrowed money.

I talk a bit about this in my piece on preparing for a recession, although its focus is mainly on the moves to make in advance of one, rather than during one.

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Guest

Thanks Philip. I have quoted you here.

http://www.chowrangi.com/how-to-beat-recession.html