Deflating Inflation

If you’ve ever been through any type of financial planning, youíve 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 … Continued

If you’ve ever been through any type of financial planning, youíve 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. Thatís 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 thatís still ongoing. Since soup lines arenít 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 itís just a couple percent a year, is that over long periods of time it can hurt your ability to maintain your standard of living. Weíve 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 itís 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 itís always mentioned in books like this.

While inflation is certainly a real and potentially serious barrier to your financial security, Iím going to tell you something that youíll 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 itís quite possible that itís 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 youíre choosing to spend your money on things that are increasing rapidly in cost and what youíre 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. Itís only 30 stocks out of about 6,000 that trade on any given day. But because itís a decent proxy for the overall market (meaning that it often does represent the same percentage move that the overall market made that day) itís 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. Hereís 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 youíre 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 donít, it doesnít. So wouldnít 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 DOLís CPI website ( one of the things youíll 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 thatís how much you had in 1980, youíll 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 theyíre the ones who will no longer have the ability to increase their income or their savings and thereby offset it. Theyíre 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.) Theyíve been gathering acorns all their lives, and now theyíve reached the time when theyíre going to have to start eating them. So their greatest fear is that theyíll 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 youíre 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.

But before we start freaking out about inflation, letís see whatís being measured. 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 BeveragesPercentage 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 ¾ of this number comes from rent and ownerís 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. Womenís stuff is a bigger chunk than menís. (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.

So how will our average retired person be affected by changes in the consumer price index? The fact is that thereís no such thing as an average retired person, but letís have a look and see if we can draw some general conclusions. 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. When it comes to housing, a person who owns their own home (whether theyíre retired or not) isnít affected by this at all, unless maybe theyíve 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 retiree 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.

Clothing isnít 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 Iíve received as Christmas presents, mostly from my sister-in-law, Marcie. And I wear it until it completely dissolves.)

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. Airline tickets certainly arenít taking wing, are they? Gas prices have certainly gone up over the years, but the availability of more economical cars has also increased. Insurance goes ever higher, but as youíll see in the insurance chapter, there are many ways to lower that cost.

Medical expenses are huge for seniors, but then again, they also have access to Medicare, which covers a large part of medical expenses. Drugs arenít covered by Medicare, but then drugs are also less than 1% of the CPI. If I wanted to cut my costs on prescription drugs, Iíd either try to get generics or visit Mexico and/or Canada every now and then, where prices are about half what they are in the U.S.

Recreation costs are about as heavily weighted in CPI as medical costs. (Iím 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 itís hardly a necessity. Iíd rather read a good book myself, and theyíre still free at the library. Another big component of recreation is club membership, and I certainly wouldnít consider joining any club that would consider having me as a member.

Education is probably not a major issue for seniors. (I know it isnít for my parents, because, judging by the advice theyíre always handing out, they already know everything.) Obviously rising education costs are a huge concern for people with young children, but as you learned in the chapter on saving for college, there are ways to deal with them that didnít exist a few years ago. As for communication, long distance is a small fraction of what it used to cost, and thereís no such thing as postage in cyberspace. Computers are getting cheaper all the time, especially if youíre willing to settle for second generation. So in this overall category, with the exception of education, thereís more deflation happening than inflation.

Most of the ìotherî category concerns itself with toiletries (can you say ìSamís Club?î) 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).

So where am I going with all this? Iím not suggesting that inflation shouldnít 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 (property taxes come to mind), but the next time Tom Brokaw tells you what the CPI did last month, donít automatically assume that thatís what it did to you or your savings. And as youíll see as you read through other parts of this book, and/or check out other sources for saving money, there are ways to compromise many price increases that come along.

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