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.

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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.