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The Insidious Effect of Inflation on Budgets

We all seem to have a basic understanding that there is something called inflation and that it means that when budgeting for the future we have to plan for things get more expensive over time.  Nonetheless very few people seem to really appreciate the impact of inflation on their financial plans or have a clear idea of how to account for it.

budgets, retirement plan and personal finance blog
With this inflation, Budgets get bigger, not balloons.

Inflation Defined and Historical Rates

Inflation is the rate at which prices for goods and service rise over time, and therefore your spending as well if you buy the same things. A popular measure of this in the United States is the Consumer Price Index for Urban Consumers (CPI-U or just CPI). Here are some key historical facts:

  • CPI Inflation in 2010 (over 2009): 1.6%
  • Average Annual CPI Inflation 2005 to 2010: 2.22%
  • Average Annual CPI Inflation 2000 to 2010: 2.39%
  • Average Annual CPI Inflation 1990 to 2010: 2.59%
  • Average Annual CPI Inflation 1960 to 2010: 4.11%
  • Average Annual CPI Inflation 1960 to 2000: 4.55%

By and large for the last 20 years the United States has enjoyed relatively low inflation, but there have been periods such as the late 1970s when inflation exceeded 10%. The US Federal Reserve is the central banking system of the USA created by congressional legislation as a part government, part private entity that regulates monetary policy. The US Federal Reserve Open Market Committee has an explicit legislative mandate to foster maximum employment and price stability (in many ways opposing goals that they must try to balance) with the monetary policy tools at their disposal. Price stability is generally interpreted as keeping inflation in the 1% to 3% range but there is no guarantee that they will always be successful and in fact they often are not.

If you want to see a detailed history of the CPI, you can find it at the Minneapolis Federal Reserve Website.

Some Potentially Helpful Inflation Facts to Consider

Inflation is not an event.  Inflation is not a crisis or tragedy that happens from time to time by accident that we need to react to.  In a modern economy like ours, inflation is constant, incessant and relentless.  There may be periods of high inflation for a time, or low inflation like right now, but in my opinion you can pretty much count on an average of at least 3% inflation every year forever and should have a plan where you experiment with and see the impact of higher rates on your finances.  Some years it is lower, some higher, but it does not stop, year after year.

Inflation is about spending.  So the place to account for it, especially when planning for the future, is in your budgets.  Your household budget 10 years from today will not be the same as it is now, it needs to be adjusted for inflation.  It also effects the way you think about money.  For example if you are thinking “what happens if I inherit $100,000 20 years from now”, chances are that’s not really the exact question you are pondering.  Most likely you are pondering what the impact of what you think of $100,000 to be right now would have on your finances at that future point in time.  If you were to try to do some math around that question, you would need to use an inflation adjusted value, which for example assuming 3% inflation would mean a value of around $175,000.

Inflation compounds.  This is so important because 3% or so sounds small, but over time it is tremendous.  I covered compounding here.

Last but not least, and maybe most significantly, inflation means we all live with financial risk, no matter how we invest or even if we don’t invest at all and hold cash.  In fact holding cash may be the riskiest choice of all, as it has a guaranteed loss of unknown magnitude.  The magnitude of the loss that comes with holding cash (inflation rate) is impossible to predict, or in other words, is a risk.

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