Considering the Proper Inflation Rate When Planning

I’m not talking about blowing up balloons or pumping air into your tires but rather a mystical force that makes money worth less over time. I’m talking about inflation. Inflation represents an increase in the price of goods and services over a period of time in an economy. In short, money is worth less. 

Risks of inflation

The biggest risk of inflation is a loss of purchasing power. According to the Bureau of Labor Statistics, the value of $10,000 in January 2017 has the same buying power as $5,246.27 in January 1990. In other words, a dollar in 1990 could only buy around half what a dollar could in 2017. If we look back another 10 years, the value of $10,000 in January 2017 has the same buying power as $3,203.77 in January 1980!

Consider this: In 1948 a cheeseburger at In-In-Out was 30 cents. Nowadays that same cheeseburger costs $2.45, a 717% increase!

A proper inflation rate

It’s generally understood inflation should be taken into consideration when planning, but what rate should be used? Using an improper inflation rate over long-term planning can be problematic. For example, using a 2% inflation rate may make some retirement plans appear successful but using a higher inflation rate such as 4% will make the plan look less successful, consequently resulting in different decisions in both situations.

Recently, inflation has been historically low. From 2012–2016 (5 years total) average inflation was 1.93%. Compare that to inflation in the 80’s, which from 1980–1984 (5 years) averaged 7.58%. The longer inflation rates remain at subdued levels, the easier it is to forget history. It can be tempting to use lower, more recent inflation rates in financial plans typically creating better looking outcomes on paper.

A well-disciplined approach to planning requires long-term perspective. While inflation rates have been low for several years, there’s a possibility we could experience another 80’s-type hyper-inflation period in the future. Using all available inflation data from the Bureau of Labor Statistics we find that average inflation from 1958–2016 is 3.74%.

While there is no guarantee long-term average inflation rate will remain constant, it’s certainly better than basing a plan off inflation rates within the past few years with no historical perspective.

Source for inflation figures: https://www.bls.gov/home.htm

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