Taking Inflation into Account
By: Source: AARP.org Date Posted: 2005-03-20 12:09:06
You paid 25 cents for a candy bar in 1970. In the 1980s, the same candy bar cost you 50 cents. Now, you can't satisfy your sweet tooth unless you've got a dollar bill in your pocket. Blame inflation for that.
Inflation
Inflation is the gradual rise in consumer prices. Because of inflation, a dollar is worth more today than it will be in the future.
There's no way to predict future inflation rates, or the pace at which inflation will rise. However, you can develop investment strategies that will help you keep pace with inflation. These strategies might even help you "beat inflation" from time to time.
How is inflation measured?
The federal government has several ways to measure inflation. The most common way is the Consumer Price Index (CPI). The CPI measures the average change over time in the prices paid by urban consumers for a "market basket" of consumer goods and services. The government announces the CPI every month.
The CPI measures how prices have changed since 1982-84. According to the Bureau of Labor Statistics, the CPI for the Year 2000 was 172.3, which means that by the end of 2000, prices had increased by 72.3 percent over price levels set in the mid-1980s.
The CPI in 2000 represented an increase of 3.4 percent over 1999's CPI, which was 166.6. This means that the inflation rate for 2000 was 3.4 percent.
A good way to measure the impact of inflation on your future purchasing power is to use the Rule of 72. Divide 72 by the inflation rate. This will tell you how many years it will take for costs to double. If the annual inflation rate is 4 percent, an item that costs $25 today will cost $50 in 18 years.
Calculating Your Real Rate of Return
Inflation can seriously affect your rate of return on savings accounts and investments. When the inflation rate is higher than the interest rate on your savings account, it's a sure sign that your money is losing value.
The same is true for your investments. You're probably not earning as much as you think on stocks and other investments. Find your real rate of return by subtracting the inflation rate from the rate of return you're earning. For example, if the inflation rate is 4 percent, and the actual rate of return on your stocks is 10 percent, your real rate of return is only 6 percent. Inflation has eaten away 4 percent of your investment income.
10% actual return
- 4% interest rate
6% real rate of return
Inflation and Your Retirement Income Sources
Keep track of how inflation affects your Social Security and pensions. The annual Social Security Cost of Living Adjustment (COLA) will help your benefits keep pace with inflation. But your defined-benefit pension plan may not fare as well. Those pension benefits usually aren't adjusted for inflation.
Your retirement planning should include an overall investment strategy that will give you a hedge against inflation. Select investments like stocks that have a record of beating inflation over time. Inflation-indexed Treasury Securities may be a good choice. The inflation-indexed Series I Savings Bond from the U.S. Treasury is guaranteed to provide returns over and above the rate of inflation for up to 30 years.
For More Information
Inflation Calculator
- The Bureau of Labor Statistics web site features an Inflation Calculator that gives you a clear idea of how inflation will affect your future buying power.
- URL: http://data.bls.gov/cgi-bin/cpicalc.pl
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