In last week’s column, we looked at the causes of inflation and the probably of higher inflation in the future. Today, we are going to look at the effects of inflation. Inflation, while not a problem today, is still a major issue when planning your long-term goals. In reality, what inflation really means to you is that as the price of everything is going up in price; the value of the dollar in your pocket is going down.
An example to help you understand the long-term impact of inflation is below. In this example, I am going to assume a long-range inflation rate of 8 percent. Granted, 8 percent may seem like a ridiculously high inflation rate now; but based on the federal debt, this may not be far off the mark when we look back in retrospect 15 years from now. If you do not feel 8 percent is reasonable, just substitute any rate you prefer and duplicate this example.
If you start with a young person at the age of 18 and give him a dollar, by the time that person is 27 years old, it will cost two dollars to buy what they used to be able to buy for just one dollar; or the original dollar will have shrunk to a value of only 50 cents. By the age of 36, it will cost $4, by age 45, $8; or, in other words, the dollar is now worth 12.5 cents. At age 54 it will take $16 and by the age of 63, around retirement, what used to cost $1 for this person on his or her 18th birthday will now cost $32; or the value of our original dollar will have reduced to only 3.13 cents.
When you view the long-term effects of inflation in this format, it’s staggering! But this example is not just my projection of the future; it is also a mirror of the past the last time inflation got out of control, between 1969-1989.
In 1969, it cost only 50 cents to go to the movies; and a candy bar or a scoop of ice cream was only a nickel and dime respectively. In 1989, it cost $5.50 to go to the movies, the candy bar cost 45 cents, and the scoop of ice cream $1. Interestingly, if you think inflation has been under control since then, ask yourself what these very same things cost today.
You might be thinking, OK, inflation used to be high in the 1970s and ’80s – but it has not been very high for the last two decade, so why are you making these type of comparisons? Like you, I had been hearing this same thing for the last couple of decades. Yet when I look at the real cost of living compared to what the government is stating as the annual CPI, I have a hard time making it reconcile in what I am experiencing.
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If you look the CPI as published by the U.S. Department of Labor, Bureau of Labor Statistics’ from the years 1994-2014, you will see that it has averaged 2.5 percent per year over this 20-year period. So, let us look what an actual 2.5 percent per year inflation over the last two decades would look like in realty.
A 2.5 percent per year inflation would mean it would take 28.8 years for the price of everything to double in cost, which is an annual increase that is almost unperceivable. That would mean for quite some time, the price of your groceries, utilities, cars, homes, college educations, medical care and insurance should have been growing so slowly you could not see any significant difference from year to year. Was it that way for you?
The fact is that in my world, almost everything I have to buy keeps going up in cost year after year – and a lot more than at an imperceptible rate. Granted, there are a few things that have not gone up, like maybe computers, home electronics or a few high-tech items like that, but just about everything else on which I spend most of my money has gone up considerable.
Then how can the CPI be different from the real inflation? The answer is that the CPI is a composite of certain items on which people spend money. The government chooses which items it wants to use in the composite and what weights it wants to give each item in that average.
However, the CPI is one of the single biggest factors that directly impacts the annual federal budget. For example, Social Security benefits are indexed to the CPI as are so many federal retirement benefits. Many parts of our income tax structure are also indexed to the CPI.
What this means is that if the CPI is 3 percent this year instead of 1 percent, then the increased cost of Social Security benefits due to indexing would be three times greater. Obviously, our government has a very vested reason to see the CPI compiled rate come in as low as possible.
Therefore, I would suggest you look at what you are seeing is happening in your cost of living increases each year to help you get a feel for what will really need to be projected in your long-term financial planning. In my next column, I will discuss what inflation is doing to your assets.