You hear it all the time: You should make sure your retirement savings at least keep pace with inflation.
But what is inflation and how does it really affect your retirement savings?
Let's explore. In simple terms, inflation is defined as an increase in the general level of prices for goods and services.
If inflation is relatively high, say 10%, as it was in the late 1970's and early 1980's, then a loaf of bread that costs $3.00 this year will cost $3.30 the next year, $3.63 in two years, and $4.00 in three years. Historically, inflation in the United States has averaged 3.24% from 1914 through 2021. However, over this more than 100-year period, it has varied quite a bit, it reached an all–time high of 23.70% in June 1920 and a record low of -15.80% in June 1921.
In 2021, inflation went up every single month, which you no doubt already know. While moderately high inflation never is enjoyable, it’s still nowhere near what some other countries have experienced. Venezuela averaged 32.47% from 1973 until 2017, reaching an all–time high of 800% in December of 2016. Hyper-Inflation what Venezuela experienced is absolutely crippling.
So how does inflation affect your retirement savings?
The answer is simple: Inflation decreases the purchasing power of your money in the future, lowering your standard of living.
Consider this: at 3% inflation, $100 today will be worth $67.30 in 20 years, a loss of 1/3 its value. Said another way, that same $100 will only buy you $67.30 worth of goods and services in 20 years. And in 35 years? Your $100 will be reduced to just $34.44, which means you are losing almost 2/3 of your purchasing power.
How is inflation calculated?
Every month, the Bureau of Labor Statistics (BLS) calculates indexes that measure inflation: Consumer Price Index (CPI), a measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser.
Producer Price Indexes (PPI), a family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPI's measure price change from the perspective of the seller.
How the Federal Reserve Attempts to Control Inflation
Believe it or not, up until the early part of the 20th century, there was no central control or coordination of banking activity in the United States. In fact, the US was the only major industrial nation without a central bank until Congress established the Federal Reserve System in 1913 with the enactment of the Federal Reserve Act. With the Federal Reserve Act, Congress set three very specific goals for the Fed:
In order to help the Federal Reserve stabilize prices, Congress gave the Fed a very powerful tool: The ability to set monetary policy. And one way the Fed sets monetary policy is by manipulating short–term interest rates in an effort to control inflation. If the Fed believes that prevailing market conditions will increase inflation, it will attempt to slow the economy by raising short–term interest rates, reasoning that increases in the cost of borrowing money are likely to slow down both personal and business spending and therefore bring demand down which eases inflation.
On the flip side: If the Fed believes that the economy has slowed too much, it can lower short–term interest rates in an effort to lower the cost of borrowing and stimulate personal and business spending. The most recent example being the pandemic, the Fed stimulated the economy by lower rates to help stave off a major recession.
As you might imagine, the Fed walks a very fine line.
If it does not slow the economy soon enough by raising rates, it runs the risk of inflation getting out of control. And if the Fed does not help the economy soon enough by lowering rates, it runs the risk of the economy going into recession.
More recently the Fed has been targeting an "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."
What Investors Need to Remember
Understanding the powerful affect that inflation can have on your retirement nest egg, it is imperative that your long-term retirement strategies account for inflation. You should prepare for a decrease in the purchasing power of your dollar over time and should strongly consider assuming that inflation will be at least 3.24%. If you're wrong and you find that the inflation rate for the next 10, 20, or 30 years turns out to be less than 3.24%, then you'll be in even better shape than you had planned.
For some things in life, it pays to be conservative.
-Paul R. Rossi, CFA
Paul R. Rossi, CFA