Money Talks

If you’ve ever been through any type of financial planning, you’ve probably heard all about, and been duly frightened by, inflation. The word inflation refers to the gradual erosion of the purchasing power of money due to rising prices over time. In other words, your money is worth less because stuff costs more. While it may seem that rising prices are bad, actually the folks who guide our economy like a little inflation. That’s because the opposite of inflation, deflation, is the stuff that nightmares are made of. Deflation, or falling prices, nearly always accompanies a severe economic downturn, like our Great Depression of the 1930s or the great Japanese depression that’s still ongoing. Since soup lines aren’t considered the result of sound fiscal policy, inflation, as long as it stays in the 1-3% range, is fine by most economists.

The problem with inflation, even if it’s just a couple percent a year, is that over long periods of time it can hurt your ability to maintain your standard of living. We’ve all heard stories of (or maybe even personally seen) loafs of bread that cost a nickel, cars that cost $2,000, houses that cost $5,000 and executive salaries of $3,000 a year. And it’s not hard to imagine that living on $3,000 a year these days would be quite a trick. So inflation quickly becomes public enemy number one when retirement investing is the topic of conversation, and why it’s always mentioned in books like this.

While inflation is certainly a real and potentially serious barrier to your financial security, I’m going to tell you something that you’ll probably never read anywhere else. It may not be as big a deal as you think. Inflation is not cast in stone, nor is it automatic, despite what many financial planners would lead you to believe. And it’s quite possible that it’s not nearly as big a threat as you might expect. Why? Because your rate of inflation, which is the only one that really matters, largely depends on you personally. It depends on whether you’re choosing to spend your money on things that are increasing rapidly in cost and what you’re willing to do about it.

Consider the consumer price index, or CPI, by far the most popular gauge of inflation at the consumer level. Every month the CPI is computed by the Department of Labor and announced on the national news with varying degrees of fanfare. But when Tom Brokaw tells you that your cost of living went up by an annual rate of three percent last month, is he being truthful?

As I explained earlier, the Dow Jones Industrial Average is not the stock market. It’s only 30 stocks out of about 6,000 that trade on any given day. But because it’s a decent proxy for the overall market (meaning that it often does represent the same percentage move that the overall market made that day) it’s used to help us understand at a glance what happened in a particular trading session. The Consumer Price Index is the same kind of thing, at least theoretically. Here’s how the Department of Labor describes the CPI: changes in the prices paid by urban consumers for a representative basket of goods and services.

But even if you’re an urban consumer, the question remains...is it representative of you?

If your family buys all the representative goods and services that the labor department tracks every month, the CPI does indeed accurately depict your personal inflation rate. But if you don’t, it doesn’t. So wouldn’t it make sense to see what goods and services the Department of Labor is tracking before we go around scaring ourselves to death with these numbers? When you go to the DOL’s CPI website (http://www.bls.gov/cpi/) one of the things you’ll find is a calculator that will tell you how much money you need today to buy the same stuff you could buy in 1980. For example, plug in $10,000 and the calculator will instantly tell you that if that’s how much you had in 1980, you’ll need $22,000 to buy the same stuff today. That kind of information certainly helps sell investments because it convinces people that not doing something immediate and commission-generating in order to increase their net worth will ultimately result in their eating out of dumpsters.

Inflation is most often used to scare people who are either retired or on the verge of retirement. Why? Because they’re the ones who will no longer have the ability to increase their income or their savings and thereby offset it. They’re no longer getting a salary that will keep pace with the spiraling cost of living. (They do, however, often receive Social Security, which in fact does have cost-of-living increases.) They’ve been gathering acorns all their lives, and now they’ve reached the time when they’re going to have to start eating them. So their greatest fear is that they’ll run out of acorns before they run out of time, especially since their acorn-gathering days are behind them. And this is a legitimate fear, since according to IRS life-expectancy tables, the average 65-year-old will live for another 21 years. So if you’re an investment salesman, demonstrating how the purchasing power of the dollar is reduced by half every 20 years is a great way to get stubborn seniors off their duffs and into stocks, which have proven to be long-term inflation-beaters.