What Is Inflation And Why Should You Care?

When I wrote a recent article about emotional investing and optimal investing strategies, I did not take inflation into account, as I was following the methodology of the Seeking Alpha article called The Shocking Returns Of The Investor Who Only Bought At Market Tops. However, the more I thought about the setup, the more unrealistic it seemed. The calculations assumed an investor starting at age 20 in 1970 saving $1,000 every month and investing at various times until retiring at age 70 in 2020. Saving $1,000 every month may be possible for someone with the median income now, although it’s often a stretch for most people, but a 20-year-old saving $1,000 every month in 1970 is difficult to fathom. Due to inflation, saving $1,000 every month in 1970 would be like saving $6,700 every month today, which would come to $80,400 per year. Given the median income was $59,050 in 2019, saving $80,000 per year is impossible for the average American. That said, the calculations in my previous article are still accurate, and consistent monthly or yearly investing is still the optimal investment strategy for long-term growth. Taking inflation into account ($1,000 now would be like $150 in 1970), you would still end up with close to $3 million after 50 years by investing monthly. Including dividends, taxes, and fees, that number would be closer to $5.4 million. Yes, that’s less than the $8.8 million I had previously calculated for investing $1,000 monthly, but it’s still a decent sum of money. Clearly inflation is important, but most people do not consider it on a regular basis, or even when planning for their financial future. What is it exactly, and does it matter for our everyday lives?

What is inflation?

Inflation is defined as the general rise in prices which makes a currency worth less than before. For example, in 2000, you could buy a pound of white bread for about $1, but now you would need about $1.50 to buy the same bread. As you can see, the purchasing power of a dollar has decreased by about 33% in 20 years. Similarly, you could buy a pound of rice for $0.50 in 2000, but now you would need about $0.75. The U.S. Bureau of Labor Statistics keeps track of the prices of these consumer goods each year. They even record the price of chocolate chip cookies (which increased in price from $2.50/lb. to $3.75/lb. from 2000 to 2020)! By measuring the average change in prices urban consumers pay for goods and services over time, the U.S. Bureau of Labor Statistics calculates the Consumer Price Index (CPI), which is the most widely used measure of inflation.

How does inflation affect me?

It should be obvious from the previous section, but inflation has a direct effect on our lives. When inflation is high, that means we have to pay more for everyday purchases. If you’re holding on to a lot of cash, that money becomes less valuable as inflation increases. This makes planning for the future more difficult. You may need $1 million to retire now, but what about in 30 years? You’ll likely need a lot more, as your money loses purchasing power over time.

What can be done about inflation?

There are several ways to combat inflation. The most basic way is through cost-of-living raises, which aim to increase salaries by enough to cover the yearly increases in goods and services. Unfortunately, due to the Covid-19 pandemic, my employer has stopped providing these raises, so this year I will receive the same amount as last year while prices increase, making it harder to afford the same expenses.

The Federal Reserve combats inflation by raising the federal funds rate, which dictate interest rates. If interest rates are equal to inflation, then keeping your money in a savings account that provides this interest will allow you to remain even with inflation. However, at the moment, rates are very low in an attempt to allow consumers to borrow money so that they can keep spending through the pandemic. That means that if you are keeping money in a savings account right now, you are actually losing money relative to inflation. Interest rates that take inflation into account are called real interest rates. Here you can see how real interest rates have changed since 2000:

Nominal interest rates (black), real interest rates (blue), and inflation (red) from 2000 to 2021
Source: Longtermtrends.net

As you can see, real interest rates (shown in blue) have been mostly negative since 2000 and almost entirely negative since 2010. This is because nominal interest rates have been kept very low in an effort to boost the economy while inflation has remained relatively constant. The Federal Reserve actually aims to keep inflation at about 2% over the long term. They believe that this helps our economy to remain healthy while allowing them to adjust interest rates as needed. However, negative real interest rates make it much harder for Americans to save money.

Since saving your money in the bank actually loses you money relative to inflation, the alternative is to invest your money. If you can find investments that earn more than the rate of inflation, you will be growing your money rather than losing it. However, investments come with risk, so there is always the chance that you could still lose your money. How much risk you are willing to take on is up to you. Some investments are riskier than others. For instance, bonds are generally considered safer investments. I personally like Worthy Bonds, which earn you 5% annually on up to $50,000 and allow you to withdraw your money and interest at any time. Stocks are considered more risky but are generally more profitable over the long term.

Summary

Inflation is a measure of much prices of goods and services increase over time and is measured by the U.S. Bureau of Labor Statistics in the form of the Consumer Price Index (CPI). When inflation is high, your purchasing power decreases, and it becomes more expensive to pay for everyday needs and wants. To combat inflation, look for ways to earn more interest than the inflation rate. When real interest rates are negative, this generally means that, despite the inherent risks, investing your money is the best option.

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