When you talk about money, and especially when you talk about retirement planning, there is a term that inevitably comes up. Inflation.
You’ve almost definitely heard of inflation before, but do you know why it happens and how it affects you? That’s what we’ll be talking about today and next week. Let’s jump right in.
What Is Inflation?
Inflation is the rate at which the cost of goods and services is rising and is measured as a percentage change. It’s what causes the absolute price of something to rise over time, though whether or not the relative price of that item goes up is a different story. Put another way, inflation is a way of expressing how a dollar buys less over time.
For example, if you normally spend $50,000 annually on goods and services, and inflation is 2%, then you should expect to spend $51,000 the next year on the same goods and services. In the real world it doesn’t work out quite that neatly for individuals, but that is what it would look like on average for Americans over time.
Why Does Inflation Happen?
There are several reasons inflation happens, although there isn’t a single accepted theory that explains it fully.
First, there is demand-pull inflation. Remember in middle school when you learned about supply and demand? That is – in really simple terms – what is going on with demand-pull inflation. If there is an increase in demand for goods and services, people will pay more. The price goes up, and you have inflation.
Cost-push inflation occurs when the cost of production of goods and services goes up. The company paying those increased costs will pass along the cost to the consumer in the form of higher prices.
Monetary inflation is what happens when a government puts an oversupply of money into the economy. This is the other side of supply and demand in terms of inflation – too much monetary supply! If there is too much money, its value will go down. That means companies will charge more for the same item, causing prices to go up.
How Is Inflation Calculated?
Long story short – a whole bunch of really smart nerdy types get together and look at the price of goods and services. Those goods and services are lumped into what’s known as a “market basket” and the change in price of that basket over time is the inflation rate.
The type of inflation you will hear about most commonly is based off the Consumer Price Index, or CPI. The CPI records the price of ~80,000 consumer items every month, using data supplied by ~23,000 businesses. As the businesses report changes in prices, the CPI is adjusted.
There is also a Producer Price Index (PPI), which measures the rate of inflation from the perspective of the companies instead of the consumers. But since everybody is a consumer, and not everybody is a producer (especially readers of Military Dollar), we’ll focus on CPI.
The CPI includes more than 180 categories, such as food and beverage, recreation, transportation, housing, and apparel. The type of stuff the average consumer is going to spend money on. The ~80,000 items within those categories stay static for awhile, but the Bureau of Labor Statistics removes goods and services every few years to stay current. For instance, can you imagine if the list still covered the price of 20” cathode ray tube TVs? Not a lot of them being sold anymore…
As the price of the market basket goes up, you (the consumer) will see prices start to rise. Not everything will rise lock-step. For instance, the food and beverage category may go up 4% while the housing category goes up by only 1%. But overall, the CPI measures how much more expensive it is to live today than it was in a previous year.
So That Means My Expenses Will Rise By The CPI Each Year?
Nope. That’s totally not what that means.
CPI is based on a hypothetical group of items. Sure, they are items many people buy and based on actual prices. But it’s not quiteeeeee indicative of reality. You are not a hypothetical. And you probably aren’t buying ~80,000 different items each month, or even each year. So your dollar’s purchasing power may equal everyone else’s purchasing power, but your personal experience with inflation will be different.
Money is valued in terms of how much goods and services it can buy at a particular moment in time. This is also known as purchasing power. Theoretically, prices for goods and services will rise at the rate of inflation, lowering the purchase power of a dollar by the same amount. In reality, it’s not quite that clean. Again – overall expenses may rise by that amount, but individual prices vary.
Inflation and Purchasing Power in The Real World
Let’s take a real world example. When McDonald’s was founded in 1955, a cheeseburger was 19 cents ($0.19). It’s now $1. That means it’s approximately five times the price it was in 1955. That sounds like a lot, but let’s look at inflation as a whole. The Bureau of Labor Statistics CPI calculator says that 19 cents in July 1955 had the same purchasing power as $1.74 in July 2017 (the last month for which data is available). That means that a McDonald’s cheeseburger has actually gone down in relative price, even though the absolute price has gone up significantly. In terms of McDonald’s cheeseburgers, your dollar has more purchasing power than it did in 1955.
By contrast, I’ve personally noticed the price of candy bars has risen far faster than inflation lately. In July 2005, I was the squadron snack officer. The most important snack I had to keep handy was a vast array of candy bars. Woe was me if somebody’s favorite candy bar wasn’t available. Anyway, I became intimately familiar with the price of candy bars. And in July 2005, the normal price for a candy bar was 33 cents. If they were on sale, I could get them as low as 25 cents.
Factoring in CPI, that means candy bars should currently cost between 31 and 41 cents if their prices rose by the inflation rate. But have you bought a candy bar lately? At the grocery store, where they are generally cheapest, I cannot find them for less than 50 cents. And that’s a rare occasion. The typical price is 79 cents. That means candy bars have risen in price at nearly twice the rate of inflation since 2005, at least in my own very detailed analysis of this important topic.
What Inflation Feels Like
As you can see, your own experience with inflation is going to be dependent on what you buy the most. If you eat McDonald’s every day but never buy candy bars, inflation may feel low to you. If you buy a candy bar daily but abhor McDonald’s, it may feel much higher than the CPI says it is.
The same will happen with the rest of your spending. If the inflation rate on housing is through the roof (ha! get it?) but you paid off the mortgage already, you might not notice a huge increase in inflation rate. Since I sold my car, I haven’t been tracking the price of personally-owned transportation costs (gas, insurance, etc) at all.
So inflation is going to feel different to everybody based on their own purchasing priorities and experience.
And if you want to get really deep – consider that this may be why some people feel like the economy is in the tank and the country is about to collapse, while others think everything is hunky dory and their lives are better than ever. Whoa.