How Bad Is Inflation Really?

This posting is on something that effects everyone, namely: inflation. Unlike large gifts of cash or lottery winnings, inflation is not really everybody’s favorite topics. Even though its unpleasant, dear reader, it does affect you!

What is inflation? Inflation is technically defined as the rate of the rise of prices of goods and services in a given economy over a specific period of time.

Why does it matter for your wallet? Two reasons. First, since inflation is defined as price erosion, a high rate of inflation will undermine your buying power. Just to illustrate this, lets say that on a given month inflation is 10%. At the start of the month, you’d pay a dollar for whatever you want to buy – say a 1/4 gallon of milk. At the end of the month you’d pay a $1.10 for the same amount of milk. That’s a problem because long term inflation can seriously undermine the value of your dollars. A second reason why it matters that the level of inflation is a benchmark that your investments have to beat. For example, if your CD or money market pays 3% annually, but inflation is at 4%, then your cash is loosing 1% of its value.

Aside from prices at the gas pump and at the drug store, the best way to examine inflation is statistically. The most commonly used indicator of inflation in the American economy is the Consumer Price Index (CPI). The CPI is essentially an average of the Bureau of Labor Statistics’ estimates of what the average Americans’ out of pocket expenses are. Its based on a basket of expenditures including housing, apparel, transportation, etc.

Now, to turn to the headline of this post: How bad is inflation really? The story is complicated, but its got at least two parts. According to historical official statistics, the annual CPI rate for the past two or three years is running at around 3%. But, there is some controversy around the CPI. How it is calculated has been criticized by some economists and some say the CPI is actually closer to around 7%. Not being an economist its difficult for me to say exactly, but my gut tells me inflation is probably a bit higher than 3%. This is based purely on my experiences and conversations I’ve had with people in DC so my views are not representative.

Since you’re interested in personal finance, I’d offer this final word of advice: Pay attention to the headlines. If your investments are seriously underperforming CPI numbers you might consider corrective action.

Thanks,

James