It’s important to understand how inflation is reported and how it can effect investments.
“If the current annual inflation rate is only 0.7%, why do my bills seem like they’re 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. ¹
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.
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 0.7% for the 12-months ended December 2015 — a modest increase. However, a closer look at the report shows movement in prices on a more detailed level. Not counting food and energy, prices rose 2.1% for the 12 months.²
As inflation rises and falls, it can have three effects on investment.
Real Rate of Return
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.²
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.³
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.