Detailed Explanation
Inflation represents the decrease in purchasing power of money over time. When inflation occurs, each unit of currency buys fewer goods and services than before. Inflation is a key factor in long-term financial planning.
How Inflation Is Measured
Consumer Price Index (CPI): Tracks price changes for a basket of consumer goods and services. The most commonly cited measure.
Personal Consumption Expenditures (PCE): Another measure preferred by the Federal Reserve for policy decisions.
Core Inflation: Excludes volatile food and energy prices for a clearer trend view.
Historical Inflation Rates
US inflation has historically averaged around 3% annually:
- 1970s: High inflation (7-13%)
- 1980s-2000s: Moderate inflation (2-5%)
- 2010s: Low inflation (1-2%)
- 2021-2023: Elevated inflation (5-9%)
- Long-term planning assumption: 2.5-3%
The Rule of 72 for Inflation
Divide 72 by the inflation rate to see how long until prices double:
- 3% inflation: prices double in 24 years
- 6% inflation: prices double in 12 years
Examples
Purchasing Power Over Time
| Year | Value of $100 (in today’s dollars) |
|---|---|
| 1990 | $234 |
| 2000 | $178 |
| 2010 | $140 |
| 2020 | $118 |
| 2024 | $100 |
Real vs. Nominal Returns
- Investment return: 8%
- Inflation: 3%
- Real return: 5% (what actually grows your purchasing power)
Retirement Planning Impact
Starting expenses: $50,000/year
| Years | Expenses at 3% Inflation |
|---|---|
| 10 | $67,196 |
| 20 | $90,306 |
| 30 | $121,363 |
Why It Matters
Inflation profoundly affects every financial plan:
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Cash Is Losing Value: Money in low-interest checking accounts loses purchasing power every year.
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Investing Consideration: To maintain purchasing power, investment returns need to exceed inflation.
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Retirement Math: Future expenses will likely be higher than today’s-retirement planning often accounts for 20-30 years of inflation.
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Real Returns Matter: A 6% return with 4% inflation only grows your real wealth by 2%.
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Salary Growth: If your income doesn’t grow at least with inflation, you’re effectively getting a pay cut.
Financial projections often account for inflation to show future purchasing power, not just nominal dollar amounts.