When it comes to wealth creation, inflation and taxes are the evil twins.
Today’s topic is inflation.
When it comes to wealth creation, inflation and taxes are the evil twins. Together, they’re the most fearsome foes you and I face in achieving a financially secure future. For your money to grow in real terms, it needs to outpace the effects of both inflation and taxes. In this episode, I want to focus on the first (and more sinister) of the evil twins: inflation. We'll tackle taxes in next week's episode.
In the first four months of 2007, U.S. inflation, as measured by the consumer price index, went up at a 4.8% annual rate. 1 If you listened to Episode 26 about the rule of 72, you learned that at this rate, it would take only 15 years for your money’s buying power to be cut in half. That means that a $60,000 salary today would be worth only $30,000 real dollars in 15 years at this inflation rate. Now that’s seriously scary stuff!
Why Does Inflation Exist?
OK, so why do we have inflation? There are different theories about the cause of inflation that have been debated by economists for a very long time. However, economists generally agree that inflation is associated with an increase in the money supply. That is, when the U.S. Federal Reserve issues more money, inflation tends to go up (you can read more about that in episode 43, about fractional reserve banking).
Measure Inflation With the Consumer Price Index (CPI)
Two measures of U.S. inflation that you’ll frequently hear used in the media are the CPI and the core CPI. CPI stands for the Consumer Price Index, which is a measure of the prices for a specific “bundle of goods” that includes items such as food, clothing, and gas. The amount of inflation is measured by the change in the cost of this bundle of goods.
The core CPI is this “bundle of goods” with food and energy removed. The idea here is that food and energy prices tend to be volatile and removing them creates a more stable index. But critics have argued that it doesn’t make sense to exclude food and energy since people in the real world certainly can’t exclude them. 2
The core CPI is typically lower than the CPI because it leaves out food and energy, which tend to go up faster than prices overall. In leaving these things out, the core CPI may very well understate the true extent of inflation.
Can You Outpace Inflation?
Inflation is scary because it silently erodes the buying power of your money. Let’s take the average price of a movie ticket as an example. 3 In 1960, a movie ticket cost about 60 cents. Twenty years later, in 1980, it cost $2.69. In 2000, it was $5.39. And two weeks ago, when I went to see Michael Moore’s documentary Sicko, I paid $10 for my ticket. Ten years from now at a 4.8% inflation rate, a movie ticket will cost $16.
Even if you get a pay raise each year that more or less keeps pace with inflation, you can still feel the effect of inflation because the prices of some items, like health care, education, and movie tickets, for example, tend to go up much faster than average.
To get ahead, your money needs to earn a rate of return that outstrips inflation. Let’s say you save $2,000 a year and put it in a savings account earning 3% a year after taxes and let’s say you do this for 30 years. After the 30 years, you’d have $60,000 plus interest of $38,005 for a total amount of $98,005. 4
But would you really have this much?
No, you wouldn’t. Over the past 30 years, inflation in the U.S. has averaged 4.2% per year. If inflation averages this same rate over the next 30 years, a 3% interest rate would actually lose ground to inflation. The effective rate would be 3% minus the 4.2% inflation rate or a negative 1.2% per year. At this rate, your $60,000 savings would erode to $50,033 real dollars over the 30 years.
This is the reason that outpacing inflation with your investing is vital. When you consider your return on an investment, subtract the inflation rate to get the real after-inflation return. It’s that after-inflation rate that matters. Your cost of living is going up, so your investments need to generate a return that keeps up with or, better yet, exceeds inflation.
Now, it can feel safe to keep the money you put away for the future in a savings account, but if that savings account earns less than the inflation rate after taxes, you expose yourself to the very real risk that the real value of your money will dwindle as it loses ground to inflation (for tips on finding a savings account with the highest interest rate, please refer to episode 150).
Now, I don’t want to leave you feeling deflated with all this talk about inflation! So keep in mind that when it comes to investing, there are some powerful things you can use to your advantage, such as compound interest and leverage, to outpace inflation. [[AdMiddle]
For those of you who want to learn more about inflation, here's a link to a table that shows the annual rate of inflation since 1913. And here's a link to a calculator that shows you how prices have changed over time.
As always, everyone’s situation is different, so be sure to consult a tax or financial advisor before making important financial decisions. This podcast is for educational purposes only and is not intended to be a substitute for seeking personalized, professional advice.
Today, I’m giving away a copy of the book The Creature from Jekyll Island by G. Edward Griffin. . This book tells the very surprising story of how the U.S. Federal Reserve came to be. This week’s winner is Nick in Marion, Iowa. Congratulations, Nick, and enjoy the book!
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· What is a dollar worth?
· Consumer Price Index 1913 – present
· Graph of U.S. Historical Inflation Rates
· Bureau of Labor Statistics
1 Bureau of Labor Statistics press release
2 See “The Fallacy of the ‘Core’ Rate of Inflation”.
3 Average price info from the Motion Picture Association of America.
4*Assuming interest is compounded annually.
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