Inflation

Inflation is an increase in prices for consumers and a fall in the value of currency. It is an unfortunate reality for savers that has to be planned and accounted for. If your money is stagnant and not being invested, it’s almost guaranteed to be losing value every single year. In the US, inflation is measured in part by the Consumer Price Index. It is managed by the United States Department of Labor and is a survey of what consumers are paying for a basket of goods and services. These numbers are then used for other government entitlements such as for Social Security to make cost-of-living adjustments.

Fortunately, inflation has been relatively low over the last several decades, approximately 2-3% per year. That, however, has not always been the case. Inflation in the 1970’s and early 1980s, for example, went into double digits. This set off high interest rates which became a drag on the overall economy as the cost of capital became expensive, stifling economic growth as businesses found it too expensive (and uncertain) to secure loans. The Federal Reserve tries to manage interest rates and has a goal of 2% inflation per year being a benchmark and the “sweet spot” for economic growth. Deflation (currency increasing in purchasing power over time) is a phenomenon that usually is a sign of economic distress that central banks wish to avoid as then people want to “sit” on capital and demand for goods and services is decreasing, causing prices to lower.

Ultimately, someone saving for long periods of time for something like a retirement needs to understand that a dollar they save “today” for their retirement is going to be worth considerably less than a dollar in 30 years. But with the “magic” of compounding interest, the goal is that the rate of return far exceeds the inflation rate. It is also needs to play into an overall strategy of what assets produce returns that consistently exceeds inflation. An example, if the current interest rate is 2% for a government bond or bank CD (plus associated taxes on that interest), and the inflation rate is also 3% , a saver is essentially “losing” money every single year because of the loss of purchasing power.

By using an inflation calculator you can gauge what your purchasing power will look like in the future and account for how that will affect your retirement.