How Inflation Erodes your Purchasing Power and Wealth
Inflation reduces your wealth unless your investment returns outpace it
Key Takeaways:
- The CPI is used to measure the rate of inflation in the United States
- US inflation has been roughly 2% per year historically
- Checking/savings accounts pay interest rates less than 2%, and so those deposits will lose real value every year
- Investing in equities & bonds is a good solution to outpace inflation
As a child, I remember asking my grandfather for $1.00 to buy a bottle of Coca-Cola from the vending machine. A great man, though not known for his open wallet, he scoffed:
“A dollar?! A Coke used to cost 25 cents!”
That conversation was my first lesson on inflation. The bottom line is this: prices rise over time, and so $1 buys you fewer goods and services years later. As inflation increases, the purchasing power of your dollars decreases.
US Inflation is Measured with the Consumer Price Index (CPI)
The Consumer Price Index (“CPI”) was introduced when the US Government began tracking rapidly rising prices in 1910's. The World War I era saw shortages in food and industrial materials, and constrained supply in these goods naturally resulted in rising prices. Amid the consternation of government officials, the Bureau of Labor Statistics (“BLS”) began collecting pricing data in 1913, and began regularly publishing the CPI in February 1921.
The sampling methodology has changed over the years, but the core goal has remained the same: “to track the average change over time in the prices paid by urban consumers for a basket of consumer goods and services.”
So how is the index created? Well, economists at the BLS use surveys to collect two threads of data to build the index:
- Prices of common goods and services
- Weightings of those goods and services as % of average consumer spend
The result is the CPI — a time-series index to measure if households are paying more or less for the same stuff over time.
So why is this useful? Because it allows us to compare the value of a dollar in the past to the value of a dollar today. After all, a dollar could have bought my young grandfather 4 Coca-Colas but me only 1.
US Inflation is Roughly 2% per Year
To understand the impact of inflation, let’s look at CPI data historically. It is incredibly difficult to forecast macroeconomic measurements like inflation, but historical data offers helpful context.
We see here that prices grow exponentially over the long-term, and so the purchasing power of a US Dollar decays exponentially. In fact, we can derive that a 2017 dollar is worth only 4.1% of a 1913 dollar!
Using the CPI, let’s investigate average annual inflation over the following periods:
This tells us that the CPI has decelerated in the near past, and that inflation is approximately 2% per year nowadays.
Your Checking Account is like a Leaking Air Mattress
Now that we know our capital (i.e. money) is losing 2% of value every year, here’s the obvious follow-up question: how do we prevent that?
To offset the effect of inflation, we need to either 1) earn income on our capital, or 2) grow our capital, at a rate greater than 2% per year.
Many savers try to solve this problem by stashing their money at the bank in a checking account or savings account. Banks, the Savers recall, pay interest on all deposits. The Savers are opting for option 1 above — the bank is paying the Savers interest income for the right to borrow, and then lend out, the Savers’ capital.
So what’s the problem? The problem is that banks pay interest rates nowhere near the inflation rate! In fact, the FDIC reports that the national average interest rate on a checking account is 0.04% (as of 2/6/17). That’s a far cry from our 2% hurdle rate!
Checking accounts are easy and convenient, I get that. Your employer directly deposits money in, your debit card pulls that money out, and you can access your cash at any time. Also, it’s important to keep enough money in your checking account to cover unexpected expenses, but no more than that. The reason is that your checking account is like an air mattress leaking air while you sleep. Every year your dollars are worth less and less.
The proper solution is not to be a Saver, but an Investor. You want to invest your capital in assets that will pay you income or grow your capital faster than the inflation rate.
Invest your Capital to Beat Inflation
Unlike the Saver, the Investor’s primary goal is to turn her capital into more capital. She knows there many ways to invest, and at the minimum she needs to keep up with inflation. Luckily for Investors, many asset classes (i.e. types of investments) have outperformed inflation historically.
As with all things in life, there is a trade-off. Investments are riskier than a checking account because there is a chance your investments will decline in value. So let’s talk about how we can mitigate this risk.
In a previous post, I gave my 5 Rules for Stock Market Investing. I show that the US equity market has historically returned 10% per year over the last 90 years, despite short-term volatility (i.e. ups and downs). That post also dives into diversification across geographies and asset classes — a great way to smooth your returns and reduce short-term volatility.
By investing your money in a portfolio of stocks and bonds, you’re more likely to beat inflation than with a checking account. But you need both! Always keep enough cash in your checking account to cover unexpected, urgent expenses and invest the rest of your wealth with a goal of capital appreciation.
We may not be able to buy a Coca-Cola for a quarter anymore, but think how much our quarters will be worth in 70 years growing at a rate of 10% per year!
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Edited by: Tom Goldenberg, Clay Crosby, & Tommy Nicholas
