The Consumer Price Index (CPI) is the way the government measures rising prices. But what's your personal inflation rate?
Inflation is a funny thing – the government keeps saying that prices basically aren’t rising at all, when you know good and well that they are.
And inflation can be scary: After all, if things keep going up in price and your salary doesn’t, inflation translates into a lower standard of living. That’s a tough enough fact to face when you’re working and at least have the potential to make more money. When it gets truly frightening is when you’re too old to work and too young to die, because then you no longer have the ability to keep up with rising prices.
Take a look at the following news story – it’s got a Wall Street economist’s overall view of inflation for 2011, as well as how much prices are expected to rise on other specific bills many of us pay. Then we’ll pick this up on the other side with a discussion of how to deal with your personal inflation rate.
As I said at the end of the story, inflation will be low again this year, unless you have to do things like put gas in the car, pay for health insurance, or send a kid to college. Which leads me to…
Your personal inflation rate
While the national inflation may be interesting to talk about, does it matter? Other than academically, no. What really matters when it comes to inflation isn’t the Consumer Price Index (CPI) you hear about on the news. It’s your personal inflation rate.
By way of explanation, here’s an excerpt from a book I wrote a few years back called Money Made Simple: It concerns how inflation is computed, but more important, how you can control and combat – at least to some extent – the impact rising prices have on your life.
Understanding the CPI
Prices for the goods and services used to calculate the CPI are collected in 87 urban areas throughout the country from about 23,000 retail and service establishments. There are more than 200 products and services sampled, but they can be broken down into the following eight categories. Here they are, along with the weighting that each category receives in determining the final overall inflation number.
- Food and beverages – percentage of CPI: 16 All manners of food and drink, including full service meals, snacks, and alcoholic beverages. A little more than half of this total comes from food and beverages at home; a little less than half comes from price changes in restaurant meals. In terms of overall percentages, alcohol and meat are about equally weighted.
- Housing – percentage of CPI: 40 About three-fourths of this number comes from rent and owner’s equivalent rent. The rest is roughly divided equally between utilities and furnishings.
- Apparel – percentage of CPI: 4 Men’s shirts and sweaters, women’s dresses, shoes, jewelry. Women’s stuff is a bigger chunk than men’s. (Astounding!)
- Transportation – percentage of CPI: 17 Little bit gas, little bit maintenance, little bit car insurance, little bit air fares, but mostly new and used car prices.
- Medical care – percentage of CPI: 6 Prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services.
- Recreation – percentage of CPI: 6 Television sets, cable television, pets and pet products, sports equipment, movie and theater admissions.
- Education and communication – percentage of CPI: 6 About half is college-related, and the other half is postage, telephone services, and computer stuff.
- Other goods and services – percentage of CPI: 4 Tobacco and smoking products, haircuts and other personal services, funeral expenses.
How does inflation affect you?
So how will the average person be affected by changes in the consumer price index? The fact is that there’s no such thing as an average person, but let’s have a look and see if we can draw some general conclusions.
Food: Nearly half of the food component of the CPI involves eating out, so if I were concerned about keeping that inflation cost down, I might eat a meal at home, then go out for desert. There are dozens of ways to pay less for food.
Housing: When it comes to housing, a person who owns their own home (whether they’re retired or not) isn’t affected by this at all, unless maybe they’ve got an adjustable mortgage. And this is by far the biggest single category of CPI. In fact, homeowners should really want this part of the index to skyrocket, since that would reflect higher home values. Ditto if our average person also happens to be a landlord. Fact is, real estate, whether rental or owner-occupied, is the single biggest savings account most of us will ever have. So inflation in this category, as long as we already own some real estate, is more good than bad.
Apparel: Clothing isn’t a very big component of CPI, but one could easily keep their costs down by buying on sale, buying used or using my method and simply not buying at all. (Virtually everything I wear I’ve received as Christmas presents, and I wear it until it completely dissolves.)
Transportation: Next to housing, transportation is the largest component of what we regard as inflation, and most of that is made up of how new cars escalate in price. Since buying a new car is pretty much a waste of money anyway, this part of the CPI could be addressed by buying used. Gas prices have certainly gone up over the years, but the availability of more economical cars has also increased, and there are plenty of other ways to save on gas. Insurance goes ever higher, but there are ways to reduce it, such as raising your deductibles.
Medical care: Medical expenses are a big deal, but at least when the average person gets older, at least they get a lot of help from Medicare. For the rest of us, there are ways to save. For example, shopping around to get the best rates, or using a high-deductible heath plan: I save a ton of money by using a $5,000 deductible policy combined with a Health Savings Account. Another idea might be to bypass health insurance entirely by going with a plan like Medishare or Direct Primary Care.
Recreation: Recreation costs are about as heavily weighted in CPI as medical costs. (I’m not sure which category recreational drugs fall into.) One of the largest components of recreation is television sets, which are certainly getting cheaper all the time. Cable is going up in price, but it’s hardly a necessity. I’d rather read a good book myself, and they’re still free at the library.
Education and communication: Education costs are a huge concern for people with young children, but there are tax-advantaged investment accounts that can help, as well as other ways to lower costs. As for communication, long distance is a small fraction of what it used to cost, and there’s no such thing as postage in cyberspace. Computers are getting cheaper all the time, especially if you’re willing to settle for second generation. So in this overall category, with the exception of education, there’s more deflation happening than inflation.
Other: Most of the “other” category concerns itself with toiletries (can you say “Sam’s Club?”), tobacco (roll yer own!) and services like funerals (note that cremations, which cost a fraction of burials, are growing in popularity) and legal (software is certainly cheaper than a lawyer, and there are other ways to lower your legal bills).
So where am I going with all this? I’m not suggesting that inflation shouldn’t be a factor in your financial planning. It most definitely should be. But inflation depends largely on the type of discretionary spending you do and therefore you have a great deal of influence on how much influence it has on you. There are certainly components that are pretty much out of your control (while you can fight your property taxes, ultimately those type of expenses are tough to influence much), but the next time some news anchor tells you what the CPI did last month, don’t automatically assume that that’s what it did to you or your savings.