How Inflation Impacts your Finances
For the past several years, inflation has been under control. The overall rate of inflation, as measured by the Consumer Price Index has been averaging less than 3%. However, in the late 1970's and early 1980's, the inflation rate was much higher and the annual increases in the cost of living were much higher. For 2011, the inflation rate was about 3%.
The Consumer Price Index is the most common measure of inflation and is determined by adding up the costs of a typical "basket" of goods and services that individuals by or use. It includes costs of food, transportation, housing, entertainment, medical care and many others. The government surveys the prices of several hundred items in over 200 categories as part of the calculation.
While the overall inflation rate has been low for the past decade, there have been certain segments of the economy where prices have increased steadily and sometimes dramatically. Medical costs have been rising at a double-digit rate and college costs have been increasing at a rate about double the overall rate of inflation.
Why is inflation important?
You must take inflation into account when planning for future expenses, particularly for retirement. Maintaining the financial lifestyle you desire in your retirement years is dependent on how much you have accumulated by the time you retire and how fast you spend those funds during retirement. Inflation rates have been low recently, but there are no assurances the low rates will continue.
Inflation can also affect your investments. Generally, higher inflation or the expectation of higher inflation often leads to higher interest rates (lower bond values) and weaker stock prices. When consumers expect things to cost more in the future, they often put less "value" on their financial assets and the prices of those financial assets fall.
What should you do?
First, pay attention to the long-term rate of inflation. Inflation cycles tend to be relatively long-term, so if there are a series of monthly inflation rates above the recent 2% to 3% level, it could be an indicator of worse things to come.
Second, be sure to consider inflation in your investment planning, especially with respect to your fixed income investments. With interest rates at low levels, it may be advisable to consider shorter or intermediate term bonds (and bond mutual funds) for the fixed income part of your portfolio, even if you have to accept a lower current return. That way, if the inflation rate increases and bond values drop, owning shorter-term bonds will moderate the drop in bond values.
Third, factor a "realistic" inflation expectation into your financial planning. It is probably foolish to expect your cost of living to increase at the recent 2% to 3% level throughout your retirement years. The inflation rate is probably more likely to rise over the next several decades than it is to fall. In addition, some of your costs, such as health care, will increase as you age.