In economics, Inflation is defined as a general rise in the price level of an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy (Wikipedia). For example, if the price of steak last year was $5 and this year it’s $6, the price of steak is said to be inflated by 17%.
The US government’s preferred method of determining inflation is with the Consumer Price Index. The Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI is intended to represent a simple basket of goods that the average person would spend their money on. However, the definition of an “average person” has resulted in changes to the composition of this basket of goods over the years.
Changes were made to CPI during the Bush administration. The Federal Reserve Chairman, Alan Greenspan, proposed a new method to calculate the basket of goods. He believed if consumers could no longer afford an item in their basket, the consumer would switch to a cheaper substitute. Under this Substitution Effect, if the price of steak is inflated, the official CPI inflation rate wouldn’t increase, instead people would just substitute steak for a cheaper good, possibly hamburger. Many economists believe this to be a guiding force in how we make our purchasing decisions during times of inflation.
Inflation in our current economy
The annual inflation rate in the US eased to 5.3% in August from a 13-year high of 5.4% reported in June and July, matching market expectations. A slowdown was seen in cost of used cars and trucks (31.9% percent vs 41.7% in July) and transportation services (4.6% vs 6.4%) and inflation was steady for shelter (2.8%) and apparel (4.2%). On the other hand, faster price increases were seen for food (3.7% vs 3.4%), namely food at home (3% vs 2.6%) and food away from home (4.7% vs 4.6%); new vehicles (7.6% vs 6.4%); energy (25% vs 23.8%); and medical care services (1% vs 0.8%). The monthly rate eased to 0.3% from 0.5% in July, better than forecasts of 0.4%. Prices of airline fares, used cars and trucks, and motor vehicle insurance all declined over the month while I saw increases in cost of gasoline, household furnishings and operations, food, and shelter. (U.S. Bureau of Labor Statistics)
Over the last 10 years, inflation has averaged around 2% per annum (represented by flat line in the chart above). Inflation has been trending upward since the middle of 2020. But what does this mean to you? Well, it means that the prices of goods and services are rising. Unfortunately, your income level may not be keeping pace and as a result, you may have to adjust your purchasing decisions.
How does inflation affect your investment portfolio? It affects it by eroding your Real Rate of Return (the rate of return adjusted for the effects of inflation). Typically, when preparing long-term financial plans, the industry norm is to include a 2% rate of inflation into the projections. It may be time to revisit your portfolio allocation and what is a reasonable rate of return to achieve your goals. If inflation continues and your portfolio isn’t adjusted, you may be losing value and not even realize it. This is the “putting your money under your mattress” analogy. Considering the current state of the economy, it may be time to speak to your financial professional to make sure your financial goals are still on track.