Inflation & Your Money

“If the current annual inflation rate is only 1.5%, why does my grocery bill seem like it’s 10% higher than last year?” Many of us ask ourselves that question, and it illustrates the importance of understanding how inflation is reported and how it can affect investments.”

Inflation is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics reports on the average level of prices when it releases the Consumer Price Index (CPI).

The CPI is a measure of the change in the prices for a “market basket” of consumer goods and services over a period of time. The CPI is developed from detailed expenditure information provided by families and individuals on what they actually bought in eight major categories: food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other groups and services.

Tip: Back in the 80s, what would have cost you $1.00 in 1985 will now cost you $2.35 due to inflation. It’s important to factor in inflation as you consider your financial future. — Source: Bureau of Labor Statistics, 2014

Whose Basket of Goods?

Many find that the government’s “basket” doesn’t reflect their experience, so the CPI, while an indicator of the rate of inflation, can come under scrutiny. For example, the CPI rose 1.5% for the 12-months ended December 2013 — a modest increase. However, a closer look at the report shows movement in prices on a more detailed level. The CPI breaks out fuel oil prices, which rose 3.6% for the 12 months.

As inflation rises and falls, it can have three effects on investment.

Real Rate of Return

Fast Fact: Historic Low. Inflation was at historically low levels in 2013, but it can range higher. The highest in recent history was in 1979, when it peaked at 13.3%. — Source: Bureau of Labor Statistics, 2014

First, inflation reduces the real rate of return on investments. If an investment earned 6% for a 12-month period, and inflation averaged 1.5% over that time, the investment’s real rate of return would have been 4.5%. If taxes are considered, the real rate of return may be reduced further.”

Second, inflation puts purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer and fewer goods. Cash alternatives — which earn a low rate of return — may not be able to keep pace with the rise in prices.

Trending Lower

Inflation, as measured by the Consumer Price Index, moved higher in 2010 and 2011 after a steady decline in 2009.

chart

Chart Source: Bureau of Labor Statistics, 2014. For the period 1/1/1994 to 12/31/2013.

Third, inflation can influence the actions of the Federal Reserve. If the Fed wants to control inflation, it has various methods for reducing the amount of money in circulation. In theory, a smaller supply of money would lead to less spending. And that, in turn, may lead to lower prices and lower inflation.

When inflation is low, it’s easy to overlook how rising prices are affecting a household budget. On the other hand, when inflation is high, it may be tempting to make more sweeping changes in response to increasing prices. The best approach may be to develop a sound investment strategy that takes both possible scenarios into account.

  • Bureau of Labor Statistics, 2014
  • Bureau of Labor Statistics, 2014
  • This is a hypothetical example used for illustrative purposes only. It is not representative of any specific investment or combination of investments. Past performance does not guarantee future results.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by FMG, LLC to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.

Copyright 2014 FMG, LLC

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