An inflation rate refers to the change in purchasing power of a given currency over time. Typically, prices rise, diminishing the value of currency. In periods marked by high inflation rates, rising prices may outpace wages, making it more difficult to buy the things you’re used to.
Keeping track of the inflation rate is a crucial part of your financial planning because it gives you an idea of how well your investments need to perform in order to maintain your standard of living during retirement. While your financial advisor needs to understand the ins and outs of inflation, it is important that you acquire this knowledge as well. Read on to find out how inflation works and what it means for your retirement planning and financial future.
Before you can understand the inflation rate, you need to know what inflation actually is. So, what is inflation? Inflation is the change in purchasing power over time, while the inflation rate shows how much prices have risen or fallen over a certain period of time. The inflation rate is given as a percentage. For example, an annual 2% inflation rate means that the overall price of goods and services has risen 2% over the course of the year. For example: something that cost $10 last year would cost $10.20 this year.
Inflation is natural in a healthy economy and is typically offset by rising wages. Goods and services may cost a bit more, but workers should generally be earning more as well. Any gap when inflation rises more than wages (or when there’s widespread unemployment) can cause a period of economic downturn, such as a recession.
The primary cause of inflation is an increase in a nation’s money supply. In the U.S., the Federal Reserve can influence the inflation rate by pumping more money into the financial system in the form of reserve account credits (a type of loan to banks).
The can also increase due to rising costs of raw materials and production. This is called cost-push inflation. Conversely, demand-pull inflation can occur when demand is higher than supply. Prices may go up, but people are making money and ready to spend it.
You can better understand how inflation works over time by looking at the change of prices in common consumer goods over the course of several decades. Here are several examples of different types of products and how their prices have changed over time.
While prices have definitely risen over the decades, wages have as well. In 1965, for example, the average median family income was $6,900, compared to $78,500 in 2020.1-3
The actual formula for calculating the inflation rate requires just two pieces of data: the price in the current/target year (T) and the inflation base year (B). From there you calculate the rate of change as follows:
((T – B)/B) x 100
The answer is the inflation rate as a percentage. Let’s find out the inflation rate of milk between 1995 and 2020 using the prices above.
((3.32 – 2.48)/2.48) x 100 = 33.87
That means the inflation rate for a gallon of milk over a 25-year period was 33.87%. On an annualized basis, that represents an inflation rate of 1.17%.
In economics, there are many indices used to track a variety of inflation rates. Here is a brief overview of the U.S. Bureau of Labor Statistics’ top inflation indexes.
The Consumer Price Index (CPI) measures the average change over time in the prices paid by urban consumers for a market basket of goods and services each month. This information is used to determine the overall pace of annual inflation.
The Producer Price Index (PPI) monitors the selling prices of domestic producers. It focuses on the sellers’ perspective rather than consumers. Goods, services, and construction products are all included in the PPI.
The International Price Program (IPP) looks at how import and export prices change between the U.S. and other countries.
Inflation in the U.S. used to be much more volatile than it is today. At one point in 1778, during the fledgling days of our nation, the annual inflation rate reached as high as 29.78%.4 Double-digit spikes occurred four times before the Federal Reserve was created in 1913, which was tasked with monitoring and attempting to moderate the country’s inflation rate.
1913 is also the year the Consumer Price Index was created, making it easier to track consumer price inflation trends. After World War I, the inflation rate spiked to 20.9% in June of 1920 until a recession occurred later in the early 1920’s. The Great Depression at the end of the decade was marked by deflation. Inflation returned with the start of World War II, although volatility petered out in the postwar era.
In the 1970’s, the Fed’s loose monetary policy meant to reverse high unemployment rates also caused major inflation, which ultimately reached 14% by 1980.5 Interest rates also skyrocketed during this period, reaching as high as 20%.
Today, the Federal Reserve targets an average 2% annual inflation rate with the goal to create price stability alongside maximum employment. In March 2021, the annual inflation rate measured by the CPI was 2.6%.
Inflation and investing go hand in hand. The performance of your investments over time influences how much purchasing power you’ll have when it comes time to withdraw those funds in the future. Creating a diversified portfolio to take advantage of growth while mitigating risk is a delicate balance, which is why it’s a good idea to work with an experienced financial advisor.
Here’s how two different types of assets hold up against inflation.
Having liquid assets in a cash savings account is certainly a good idea for short-term financial needs. But holding all of your wealth in cash can have a diminishing effect over the long-term. If inflation rises a steady 2% per year and the return on your cash is less than that, your savings loses value over time.
Stocks represent a greater risk than cash in terms of volatility, but they can be a useful tool to fight against inflation particularly in the long-term. Your advisor can help shift your portfolio assets based on inflation and other economic factors.
A moderate inflation rate is normal and even healthy for a growing economy. And while it’s important to monitor inflation on your own, your financial advisor is another trusted resource to track this rate and ensure your portfolio is well positioned for a high inflation environment.
Prepare your wealth for the long-term by contacting Dowling & Yahnke Wealth Advisors today.