Personal Financial Indicators: How Inflation is Measured

As a society, we expect prices to increase over time. In fact, we hardly bat an eye when we head to the grocery store and see a loaf of bread costs more than it did the previous year. These price increases are the result of inflation and it affects everything from your personal finances to your investments. To many of us, it’s frustrating to know that the dollar just doesn’t go as far as it used to compared to the past decades. However, understanding how it works, how inflation is measured, and how it affects your finances will levy the frustrations and insecurity over future inflation.

What is Inflation?

We feel the effects for sure, as most of us can remember a time when we could fill up our cars for under $15. In 1980, the average cost of a gallon of gas was $1.22. Accounting for inflation, in today’s dollars that’s $3.95 a gallon. In fact, back in 1980, just a simple $20 bill could buy you almost $65.00 worth of just about anything today.

Really, these price increases are what inflation is all about as it’s simply the rising cost of goods and services. Inflation is also the decrease of currency’s purchasing power. This is exactly what people are referring to when they say, “The dollar doesn’t go as far as it use to.”

Causes and How Inflation is Measured

Inflation is directly related to supply and demand – in other words, the spending patterns of the public. Prices increase for several reasons, including low supply and high demand, as well as an increase in the cost to manufacture goods. It’s called the cost-push theory and is one explanation of inflation. This is why we see an increase in energy prices when the cost of oil increases.

A secondary explanation for inflation is called the demand-pull theory. This is when there’s too much money in circulation. It follows the same principle as supply and demand. Economists attribute this theory as the primary reason for inflation. According to the famous economist, Milton Friedman, inflation is always and everywhere a monetary phenomenon in the sense that it is caused by an increase in the amount of money circulating.

Even though businesses and manufacturers can influence and change the price of consumer goods, they do not determine the inflation rate nor measure it. Those who work at the Bureau of Labor Statistics (BLS) measure inflation using two different price indexes. The Consumer Price Index (CPI) measures price changes through your perspective as a consumer. These prices are what you pay at the store. The producer price index (PPI), on the other hand, measures the average price change over a period from the seller’s perspective, such as raw material and cost of labor.

How Inflation Impacts Your Financial Future

Rising prices effects absolutely everyone. It costs more to fill your tank, heat your home, and buy your groceries. When the rate of inflation increases, the cost of living increases. Even though we view inflation as mostly negative, you may get lucky if your income increases in response to inflation and increased cost of living. This is known as income inflation.

Inflation also influences interest rates, causing them to rise – a pain we may feel when borrowing money. The Federal Reserve Bank uses the CPI and PPIs to determine interest rates and the monetary policy. As interest rates go up, so too does the cost of borrowing money, which makes it more difficult to pay down debt. However, it also means getting a higher return on savings.

Although inflation effects everyone, it especially affects retirees and people living on a fixed income. With inflation, as the value of the dollar decreases, so too does your purchasing power. This means, if you’re saving for your retirement today based on the cost of living for today, you may come up short when you retire.

Furthermore, pensions and fixed annuities in retirements may not increase with the rate of inflation. This means you may not be able to cover your cost of living with your current pension payout. However, unlike the income you receive from your pension or retirement account, Social Security payments do adjust with the rate of inflation, adding some security to future planning.

Planning For Inflation

Inflation is not necessarily something you can plan for as it changes with the market, but it is something you need to consider in your retirement planning. If you want a certain lifestyle when you retire, you’ll want to plan your finances around what the cost of that lifestyle may be when you retire considering inflation. Our goal at Vector Wealth is to help you plan for the known and unknown when it comes to your future, and that includes inflation.

CID: VWM16102020