What exactly is inflation? What is its impact on your retirement savings?
You probably hear often that you should be checking to see if your savings for retirement is keeping up with inflation. Let’s start off by figuring out what exactly inflation is. To put it without jargon, inflation is the increase in the general price for goods and services. This means deflation is the exact opposite and is the decrease in the general price of goods and services. In the 1970s inflation was high at 10%. This means that one year in the 70s a gallon of milk could have cost $1, but the next year it would cost $1.10.
In the United States, the inflation’s average has been around 3.29% from 1914 until 2016. In June 1920 inflation hit an all-time high of 23.70%. Exactly a year later in June of 1921, inflation hit an all-time low of -15.80%.
This brings us back to the question of how does inflation impact your retirement savings? Inflation decreases the purchasing power of your money in the future. As demonstrated in the example above, if inflation is 10%, and you have $1 to buy a gallon of milk one year, then that $1 wouldn’t be enough to buy it the next year.
To give another example, $100 today at 3% inflation will be $67.30 in 20 years. The $100 lost 1/3 of its value over this time span. So that $100 would buy you $100 worth of goods today, in 20 years it would buy $67.30, and in another 35 years, it would only buy $34.44.
How is inflation calculated?
The Bureau of Labor Statistics calculates the indexes that measure inflation every month.
- Producer Price Indexes: PPIs measure the change in the price of goods and services from a seller’s perspective. These are a group of indexes that measure the average change over time in the selling prices of domestic producers of goods and services.
- Consumer Price Index: The CPI measures the change in the price of goods and services from the consumer’s perspective. It measures the change in the price of things such as food, clothing, automobiles, and gasoline.
The Federal Reserve tries to control inflation
Until the beginning of the 20th century, there was not a central control of banking activity here in the United States. Until the Federal Reserve System was established in 1913, the United States was the only major industrial nation without a central bank. Congress set three specific goals for the Fed when they enacted the Federal Reserve Act. The first was to promote max sustainable employment, second to stabilize prices, and third to moderate interest rates long-term.
To help the Fed stabilize prices, Congress allowed them the ability to set monetary policy. A way the Fed sets it is by controlling short-term interest rates to control inflation. If the Fed thinks that the conditions of the market will lead to an increase in inflation, then it will try to slow the economy by bringing up the rate of short-term interest. The reasoning is that if there is an increase in the cost to borrow money that personal and business spending will slow down. This means the opposite is also true. If the Fed thinks the economy has slowed too much then it will lower the rate of short-term interest. The reasoning is that if the cost of borrowing money is lower then personal and business spending will be stimulated.
If the Fed doesn’t slow the economy quick enough by raising rates then inflation could get out of control. If it does not help the economy then there is the risk of the economy going into recession. The Fed currently operates on the belief that “inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Fed’s mandate for price stability and maximum employment.”
Investors need to remember this
It is absolutely necessary that your retirement strategies account for inflation. You must prepare for a decrease in your dollar’s purchasing power over time. It is safe to assume inflation will sit at the historical average of around 3%.
To discuss your retirement plan or to get one set up, talk to the financial professionals here at NEST Financial. Visit our website to contact us.
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