Updated on 07.12.07

Are Inflation Rates Accelerating? How Should I Plan For It?

My wife’s grandfather likes to regularly comment on how fast the price of everything seems to be increasing lately. He’s loudly adamant that the rate of inflation is actually speeding up and that prices are doubling faster and faster and faster. He strongly encourages me to estimate high for inflation when I do my financial figuring.

Whenever someone declares something that adamantly, especially someone that I respect as much as her grandfather (anyone who is old friends with a Nobel Prize winner and can have eloquent discussions on almost any topic will earn my respect quickly), I’ll usually check out what they’re saying, even if my initial reaction is to write it off as ramblings. I took a deep look at the detailed inflation data over the history of the United States, using the consumer price index as a baseline. I calculated the average annual rate of inflation over ten different time bands to see what the change was like. Feel free to play around with that tool using different starting and ending years – the numbers are quite interesting.

What I found was that the really bad period of inflation in the United States was in the 1970s, a simple fact that many economists could tell you. If you look at the ten years from 1973 to 1982, the average annual rate of inflation was an astounding 8.99%. This means that prices from January 1, 1973 to January 1, 1983 went up 136%; in other words, a car that cost \$5,000 on January 1, 1973 would have cost \$11,826 just a decade later. That’s an incredible amount, an inflation rate that seems alien to people my age.

On the other hand, over the most recent ten years in the calculator (1996-2005), the average annual rate of inflation is only 2.46%. To use that same car analogy, if you bought a car on January 1, 1996 for \$5,000, that same car on January 1, 2006 would cost only \$6,375.

My wife’s grandfather’s thesis is pretty clearly incorrect – inflation is a lot better today than it was a few decades ago. However, even asking this question brings up an interesting one: how much inflation should one plan for?

If you plan for low inflation rates, then every year with a high inflation rate hurts you. For example, let’s say you planned to have an annual income equivalent to \$50,000 a year now when you retire in 30 years and you assume a 2% inflation rate. This means you’re expecting to have an income then of \$90,568 a year. A thumbnail calculation says that you can reach that level of steady income by having 25 times that in your portfolio when you retire, so you plan for a \$2.2 million portfolio when you retire. What happens, though, if inflation averages 4%? Your planned \$90,568 a year retirement will still happen, but that money will only have the buying power of a \$27,900 salary today! Moving from an income of \$50,000 a year to an income of \$27,900 a year is a major letdown.

If you plan for high inflation rates, your annual amount for retirement is much higher now, but every year of low inflation helps you. Let’s say, again, that you plan to have an annual income equivalent to \$50,000 a year when you retire in 30 years, but this time you assume a 6% annual inflation rate. This means that you’re planning for an annual income of \$287,174.60 when you retire. A thumbnail calculation says that you’ll need a \$7.2 million portfolio to retire with an annual income like that – ouch! However, let’s say that inflation averages 4% here? Your planned \$287,174.60 will still happen, but that money will have the buying power of an \$88,000 annual salary today! Moving from an income of \$50,000 a year to an income of \$88,000 a year is wonderful!

Because of this, I strongly encourage you to estimate high when figuring for inflation because you’re always better off having more money when you retire rather than less money. This way, if my wife’s grandfather turns out to be right, you’re not caught with a poor retirement plan, but if he’s wrong, you’ll be going on European vacations when you retire.

1. Grant Boston says:

From his viewpoint your grandfather may be right in saying that prices are going up, he is looking at different purchases than he did earlier in his life. The prices he sees everyday are food, utilities and fuel. He probably doesn’t have a mortgage, or looking for a new house, or buy consumer electronics (which are probably decreasing in price).

So how fast are food and fuel prices changing? I know that where I live food and fuel especially have increased price far in excess of inflation but they are not very big influences in the natiowide inflation calculations. To your grandfather and anybody on a low income these purchases have more direct impact than the inflation rate.

2. Jason says:

Trent, I personally like to take CPI with a grain of salt, considering all the cost data that’s left out (food and housing being the main ones). Did you factor that into your calculations? I’m with you on factoring needs conservatively, though (estimating low investment returns and high inflation seems so much safer).

3. Amy says:

Your grandfather is also right that while the rate of inflation may be lower than in the past, the dollar increases in price are probably coming faster than they ever have for him. 10% inflation when the baseline price of something is \$100 means the same absolute price increase as 1% inflation when the baseline price is \$1000.

4. dong says:

One other issue with the CPI data, and inflation data is that it doesn’t account for standard of living adjustments. The oft cited example is cable where let’s say 20 years ago you got 20 channels for \$15/month, but not you get 100 channels for \$75/month. The way CPI is calculated, the cost cable hasn’t increased. It’s stillt he same price per channel, but realistically you’re probably paying more your cable package. In itself measuring inflation in this manner is not wrong, but is somewhat misleading. A better measure of “real” inflation is to index some standard of living to average wages or something like that.

5. MossySF says:

Also remember the CPI formula has changed. The numbers are not directly comparable to 70s/80s numbers. Previously, CPI tracked M3 (money supply). After the formula change, CPI decoupled with M3. And now the Fed no longer even publishes M3? The conspiracy theorist in me says they do it so hide the fact that CPI is under-reporting inflation.

6. Tordr says:

I would agree with Jason that wants to take the inflation statistics with a grain of salt. In fact take all your calculations with a grain of salt, but always assume a high rate of inflation, because that forces you to save more.

When you retire the amount of money does not matter, the only thing that matter is if you have enough money to live well in the last days of your life. You do not know how your country will look in 30-50 years, anything can happen. Look at the collapse of the Soviet union. Look at Zimbabwe with runaway inflation. Look at the price of fuel that have gone up the last years, look at the bigger picture http://en.wikipedia.org/wiki/Image:Oil_Prices_1861_2006.jpg . Never assume that a monetary catastrophe cannot happen to the US also, it has problems with all its dept.

But rather look at what you want to get with your money once you retire. You want a house with no dept (so no bank can take it away) and enough funds so you do not have any money worries when you are old.

The real rates of inflation might be higher than those reported, as they are now correcting for the fact that you can buy better stuff for less money. E.g. hard dives are getting cheaper and bigger.

7. j2r says:

Having lived in a country with inflation as high as 30%, I gotta tell you that it’s quite HARD to plan things factoring inflation, because you never know what the inflation next month will be.
The economy dynamics change. Merchants stop accepting credit cards (Because they get paid a month later, which means a huge loss), or they can charge a fee just to accept credit cards.

It feeds on speculation. You can’t tell what’s real. A merchant might sell one merchandise for \$10, and a different merchant generally with the same price, could sell it for \$13 simply because the second merchant acquired the product later in the month.

I was too young at the time, so I didn’t have any experience with money savings/investment.. Only regular spending.

But if high inflation ever hits US, I would consider putting most of my retirement funds in inflation protected bonds. Even if it doesn’t give me the best return, at least I’ll be insulated from speculation.

8. Flexo says:

Above commenters are right in that you can’t really compare today’s reported rate of inflation with those of the 70s and 80s as they are calculated differently. The CPI is less of a statistic than a marketing tool.

9. Tyler K says:

I looked and couldn’t find an answer to to this question. Is the inflation rate based off the previous year (increase 3% every year), or is it based off a single year in the past? If it’s the former 3% a year for the last 20 years is going to add up.

10. rkt88edmo says:

I think inflation is actually over reported. The inflation does not take into account the change in the nature of the goods delivered to us.

Using the car as an example, a car from 1997 does not have as many airbags and safety features like anti-lock brakes & probably got lower mileage. At the time those were premium features which are now part of many standard model packages. Think about TVs, and home appliances as well.

Technology increases the value of goods in ways that is not considered by inflation calcs.

11. Michael Langford says:

I think the “planning for inflation” thing is a little out of wack. You need to plan for the *things you’ll want and need to buy* when you’re older.

For instance:

Post-secondary education has gone up (at least recently, in my part of the country, the urban south) at about a price of 8% annually.

Healthcare costs way outpace inflation as well.

You need to plan for *greater* than inflationary growths in these arenas. If you factor out “consumer goods” and just cost in needs (and that includes cars), inflation is much higher than the CPI.

Then again, things like electronics, clothing, and other manufactured goods will likely decrease in cost as further automation brings their cost down. So once you’ve met your nut of the stuff you must have, your money will go farther. However, to get to that place…you’re going to have to spend more than you think.

–Michael

12. Jeremy says:

Trent,

Have you seen sites or statistics like the ones from shadowstats.com?

If you calculate inflation the way they did in the 70s and 80s (and why shouldn’t we be calculating it in the same way, really?) inflation has averaged about 6% over the past five years, with the official number averaging somewhere above 2%.

Inflation is much higher than what is officially reported. Take the red pill, Trent, the more people who are aware of a closer reality, the better.

13. EdTheRed says:

In Fort Lauderdale, Florida in 1999 we were paying \$1.19 per gallon of gas. Others say we were paying \$1.17 per gallon (http://www.floridataxwatch.org/research/researchreports/gastax.html bottom of page) but that’s close enough for Rock & Roll.

Today we are paying \$2.89 per gallon.
It’s been pretty much been acknowledged that our economy lives and dies on energy. Much of this energy comes from oil. If you use the projected price of oil in the next ten years as your guide you’ll have a pretty good grip on what inflation will be.

If you are optimistic then by all means factor in things like greater efficiency, alternative fuels including nukes and (for consumers) hybrid engines*.

BTW, I plan to ignore (again, my own opinion, I may be wrong) hydrogen cars, at least until it is practical to manufacture it cheaply, to deliver it economically, and to store it easily.

*The internal combustion part of the equation can and should be designed to run on gas, LP, ethanol E85, etc., i.e. true flex-fuel vehicles.

14. Dan says:

“Core” CPI, the one usually reported, is now calculated as CPI – Food and Energy so it really, in my opinion, just shows the value of cheap imports of goods and does not really reflect on inflation any more.

Try the website linked to my name (St Louis Fed)above for some charts. (Or you could just go buy a gallon of milk :-)

15. SammyD1st says:

Excellent point on inflation (regardless of how the actual value is calculated). Inflation is actually the very reason why I never have an “emergency fund” when I have outstanding consumer debt. Any money left in a savings account is really getting roughly 5.05% nominal APY – 2.5% inflation = 2.55%, then factor in 25% income tax on the interest to get a real return of 1.9%. In my opinion, worthless.

16. gordon says:

Reminds me of the old story of the poor couples in Germany immediately after World War I. Old families near retirement had saved for years only to find in a matter of days that the money they had saved was worthless. In order to make reparations payments the German government printed money as fast as it could.

The value of currency would change so quickly that people would have to take wheelburrows of money just to buy bread. Just one more reason to diversify your investments.

17. lorax says:

I’m glad people pointed out that the method of scoring has changed, the values just aren’t comparable. Take a look at the individual numbers in the CPI now, many required things are rising fast but these are offset by hedonic pricing of consumer items… oh, and by cheap goods from overseas manufacturing.

Also remember that we often hear about the “core” CPI; this leaves out food and energy which have been increasing.

The CPI as it relates to TIPS and Series I bonds uses CPI-U, the urban index of inflation. Your experience in the boonies can be quite different.

18. I won’t bore anyone with the link, but research I have seen shows that the long term REAL (inflation adjusted) return is 5%. So, I like to use this in my calculations. (8% return + 3% inflation, 9% + 4%, doesn’t matter)

19. UncleOxidant says:

Trent: I think your wife’s grandfather is absolutely correct: inflation is speeding up. The thing you have to remember is that when the CPI was calculated in the 70’s it included things like food and gasoline – stuff that normal people like you and me have to buy. However, in the 90’s the CPI was re-formulated so that food and energy are now excluded from the core rate of inflation. So, while the government may be telling us that inflation is something like 2.5%, if we were to use the old 70’s formulation it would probably be somewhere closer to 6 or 7% right now.

20. David Hunter says:

Good, I am glad you are aware of this. One thing that bugs we about many personal finance sites and especially articles is that they rarely inflation adjust the future value of money appropriately. i.e. they tell you with the magic of compound interest you can retire with a million dollars, not mentioning that that million dollars isn’t going to go a long way in 30 years…

21. plonkee says:

I’m pretty certain that inflation in the UK was much higher in the 70s than it is now. I always try and inflation adjust my calculations so that I have a better idea of what I need and I plan for returns that are inflation + X% where x is quite small.

22. Brip Blap says:

I think Michael and j2r had good points. If you look at inflation as a whole it’s tolerable in the US. But in some areas (energy, education and health care) the growth in costs is much higher, and could really affect retirement planning. I think health care, in particular – who knows what means testing might be in place for Medicare in 20 years? That growth means that I will definitely be taking the ‘assume the worst and hope for the best’ scenario in my retirement planning.

Also, having lived in Russia during a period of hyperinflation I can say that there’s nothing so demoralizing as paying 10 for a thing one day and 18 for it a week later, let alone 340 a year later.

Plus, having your currency denominated in thousands is depressing – paying 27,000 rubles for a Big Mac was just psychologically unpleasant, even though as an American my underlying salary was dollars and it didn’t affect me as much as my Russian colleagues. I hope we never, ever see something like that in America.

23. Lisa says:

Inflation is relative to what you purchase. Food is up big time. Milk at now \$4 a gallon when 5 years ago it was \$2.50. Thats way more than 2.46% per year. A movie ticket was \$7 and now it is \$9.50 in 5 years. The rate of inflation doesn’t count food the same way it did 20yrs ago. I would agree that some basics are down ie color tvs(not hd type)and washer/dryer. Food, gas, insurance and property taxes, base things we all need are way up. Seniors would feel these big time in their budgets.

24. nightingale says:

I would suggest people read this article about how the decrease in fuel supply and increasing energy expenses will influence inflation:
http://www.financialsense.com/editorials/cooke/2005/0412.html

In essence: while current inflation perhaps makes prices seem high, whether or not compared to the 1970’s this may be significant. Unfortunately, this increase today will seem little in comparison with the future years as oil prices more and more steeply affect the prices of good which rely upon energy for transit, such as food, medicines that require petroleum during production, transportation, retail, wholesale, agriculture, construction, and manufacturing enterprises, to name a few.

So inflation will most likely increase more sharply in the coming years and fuel continues to have high demand but diminishing resources.

25. gordon says:

TVs are not down. The type of tv you are used to is now considered a bottom dollar option compared to when you first bought it. It you consider this year’s high end tv to that made ten years ago then you will see that the new tv is higher in price.

26. Rxforfinance says:

Whether TV’s or washer/dryers are same or down in price compared to a number of years ago doesn’t much matter.
That is becase you only buy those items once every 10+ years.
Sure when I buy my next washer/dryer and it is less than my last one it will be nice, but I buy milk almost every day and it has increased.

27. heather says:

rkt – the CPI has already been adjusted (so-called “hedonic adjustments”) for the increasing quality of items.

28. vh says:

The base cost of day-to-day living is what matters when you’re well into retirement: taxes, food, fuel, medicine, the roof over your head. Cars & televisions are likely to be irrelevant.

My father retired in the late 1960s after he passed his retirement goal of \$100,000 (a lot more than it is today). With that money he was able to buy a house outright and cars for himself and my mother, setting them up in modest comfort with no debt. He never bought another automobile, another new television set, or another major appliance–didn’t need them.

But by the end of the 1970s, the proceeds of his investments plus his Social Security were barely enough to live on. My mother died; he promptly married a woman who had her own pension (my mother had never worked). Between the two of them, they never went hungry, but their lifestyle was a great deal more Spartan than most of us would crave. . .crammed into a three-room apartment with another adult, with no money to go out to dinner or movies or take even a short trip, is not the way I hope to spend the last years of my life.

My net worth will be at least a million dollars by the time I can collect full Social Security (in three years). A million bucks looks to me about like a hundred grand looked to my father–mighty fine! But there’s just too much probability that it won’t support a middle-class lifestyle all the way through my 80s and into my 90s. That’s why I intend to work at least until I’m 70, or until they cart me out of the place.

29. Bill says:

@vh is right

You can find plenty of 50+ old insurance company print ads featuring a couple happy to have retired on a \$300/month annuity

Even a million dollars for retirement doesn’t seem like much money

Maybe a million plus a private pension plus social security income plus income from a few rental units. :)

30. John R says:

If you’re going to talk about money, you need to understand that inflation is a hidden govt tax. It is used to steal wealth from citizens by politicians without the problems of an actual formal tax hike.
About a month ago on the TV Wall Street Journal Report, famed investor Jim Rogers said that the govt is lying about inflation. Straight talk from somebody who knows what he’s talking about.
As our govt overspends and misallocates, they will print more dollars, causing inflation. That means your money is worth less since there are more dollars in circulation. That’s why they stopped reporting M3. That’s why they play games with “core” inflation rates and other confusing terms. They don’t want you to know the truth. And of course, most people not only don’t know, they don’t care.
Don’t rely or believe the corrupt ones in Washington. Learn all you can. It’s painful and time consuming, but better than being skinned when your \$1 becomes worth 10 cents.

31. plonkee says:

It seems unlikely that inflation in general is caused by the government printing more notes (although when they do print to excess, that certainly causes/exacerbates inflation) since most money is never printed, it exists merely in bank accounts and so on.

32. Peter says:

What ever happened to keeping track of your investments and adjusting? I remember a bunch of college students I overheard in the early 80’s said they were making a killing taking out student loans at 8% and investing them in CD’s at 12-14%. I’d like to think there might have been other ways to get good returns. The people who really get screwed are the ones who only have money siting in a bank account.
Sure you might not get the retirment you dreamed of, or have to work a couple of extra years, but at least you shouldn’t be stuck with nothing.