Expressed as an annual percentage, inflation is an important measure of the purchasing power of the currency of a nation and has implications on the cost of living of individuals and the overall pace of economic growth.
What is inflation?
If you've gone grocery shopping or filled your gas tank lately, you’ve most likely experienced the effects of inflation firsthand. Inflation is a measure of the rate at which the price of goods and services in an economy increases over a period of time. When prices rise, your money buys less.
How is inflation measured?
Economists attempt to measure inflation through methods such as the Consumer Price Index (CPI). The CPI establishes the price of a basket of goods purchased by typical consumers, such as food, housing and clothing, and measures the change in the price for the basket of goods over time. The percentage change in the price of the basket is used as an estimate of the amount of inflation in the economy overall.
Erodes purchasing power
The most familiar problem posed by inflation is the erosion of purchasing power. As inflation occurs and commonly purchased household goods become more expensive, a single unit of currency loses value as it buys fewer goods and services. This impacts the cost of living for individuals, who would then be able to buy fewer items. See the illustration below on the diminished purchasing power of $100 after 50 years.
Investors who earn less than the rate of inflation on their investments are challenged by reduced purchasing power when the investments are converted back to cash. Over the long term, this means that the cost of a comfortable retirement may keep climbing.
The impact of inflation on long-term saving
When saving for a long-term goal, we typically plan for the future while being very much rooted in the present. Often the dollar value assigned to our finish line is the cost of items today – and doesn’t account for the impact that inflation can have on the purchasing power of our savings over time.
For savers and investors, inflation erodes the purchasing power of their investable assets. This is especially true of cash. An under-the-mattress approach to saving would mean $100 today would only be worth $97.09 next year, at a 3% inflation rate. Over time, the impact of inflation is greatly amplified, with that same $100 worth only $74.41 a decade later. Using a very conservative approach, anyone saving to purchase a home, fund their children’s education or retirement will almost certainly find that the real return on their investment won’t keep pace with the increased cost to fund their goal. Practically speaking, this means investors need to save more or achieve a higher rate of return on their investments to offset inflation.
Increases long-term costs
Inflation can have a significant impact on costs that will be realized years in the future. For younger investors with a long time horizon, inflation has many years to compound, with the cost of living increasing with it. As an example, if inflation were 3% every year, a cup of coffee that costs $2 today would cost $2.69 in 10 years, and getting more expensive with each passing decade. Using the same example with an annual inflation rate of 5%, that same cup of coffee would cost $3.26 in 10 years, $5.31 in 20 years, and $8.64 in 30 years. It should come as no surprise then that you will need much more money in the future compared to today, just to maintain your same standard of living.
Protecting yourself against inflation
No one can completely avoid the effects of inflation. However, a sound investment strategy as part of your financial plan can guard against inflation and help maintain your purchasing power and standard of living in retirement.
Talk to your financial advisor today about building a financial plan that will put you in the driver’s seat for the long term.