Inflation: What Is It And Why Does It Happen?

"Inflation is the overall or specific increase in the cost
of a good or service."

Thank you, Mr. Dictionary.

Inflation is when your mom or dad complains about the prices
they have to pay nowadays compared to what they paid when
they were a younger.

"I remember when a candy bar only cost a nickel." "I used
to buy gas at that station for 15¢ a gallon." "When did
milk get so expensive?" "You paid HOW much for your home?"

Inflation in America has been relatively steady. There have
been some periods of high inflation, such as was seen in the
70's, but on average inflation in the US has been steady at
about 3% for the past 30 years. Some countries have
experienced inflation above 1000% in a single year.

The 3% figure is also pretty close to the average as you go
further back in US history. So we will use the 3% figure as
we discuss the effects of inflation.

A detailed analysis of the cause of inflation is beyond the
scope of this short article, but we can mention some things
that tend to cause inflation.

Increases in government taxes and fees can lead to inflation
(especially when businesses are taxed). When the cost of
business goes up, product prices go up. When prices go up
your income effectively goes down. Then you have to work
harder or find a better job. Or hope that your employer
will give you a raise.

Which then makes the business costs go up and so prices go
up and so on.

Also when your personal income taxes, property taxes, sales
taxes, auto registration fees, etc. increase you are forced
to live on less or hit the boss up for a raise.

If you get your raise (and several of your co-workers also
are given raises) the cost of doing business has gone up.
The business will then pass the extra costs on to their
customers - inflation.

Inflation can also be caused by scarcity. If there are only
a 10,000 Beanie-Babies, "Tickle-Me-Elmos",
"Chicken-Dance-Elmos", or what ever the current toy-craze
is, and there are 100,000 people that want one, the price is
going to go up.

If mad-cow disease causes cattle ranchers to destroy large
portions of their herds and there is less beef on the
market, the price of beef will go up.

If interest rates go up, inflation can also result. If it
costs more to borrow money, the cost of doing business has
gone up and so will product and service prices.

For the last 10 years inflation has been relatively low. It
is my uneducated opinion that inflation has been minimal
because people have relied on the stock market boom of the
90s to supply extra cash. Also many people have taken on
additional debt rather than curtail their spending.

But people can only stand so much debt. Once you are maxed
out on your ability to pay (you may never max out your
credit limit as long as you keep paying on time), you will
either have to reduce your lifestyle, beg for a raise or
find a higher paying job.

I predict that once the majority of middle-class America is
saturated with debt, inflation will begin to rise or the
economy will stagnate for years until some of the debt is
paid down or people's homes appreciate so that they can
borrow more money against them. (Yes, you will be getting
further into debt, but at least you can buy that new boat.)

For the most part, regular, steady inflation has little
effect on our day-to-day living. Most people get a pay
raise every year or every other year that either keeps pace
with inflation or helps them move a bit ahead.

But when you are looking at the long run and making long
term plans, inflation can have a big impact.

For example if you are 30 right now, wouldn't it be great to
retire with a million dollars when you are 60. You could
live on that forever. Right?

Well, let's factor in just 3% inflation for 30 years and see
how much your million will buy then. After 30 years of 3%
inflation, one million dollars will buy about $400,000 worth
of goods and services. That's 60% of your money gone to
inflation.

If you were counting on a monthly retirement amount of $2778
each month for 30 years, you now only have the equivalent of
$1111 each month. Less than half! Could you live on $1111
a month?

Sure you may have your home paid for and you won't have to
buy expensive work clothes or pay for lunch every day, but
your medical bills will go up as you get older and your
insurance costs will increase. Also you may want to golf or
travel more than you do now. You will have more time for
hobbies; how will you pay for them?

The biggest problem I see with a lot of long range financial
planning, especially retirement planning, is that people
forget to factor in the effect of inflation on their
investments and savings.

You may be able to live on $2778 a month at today's prices,
but could you live on $1111 at what prices could be 30 years
from now.

So what can you do about inflation? Really nothing. It is
out of your hands.

But when planning for the future you can include it in your
calculations. If you want to live on the equivalent of
$2778 a month when you retire 30 years from now, you need to
plan to save/accumulate $1.8 million and have it invested at
5% after you retire and want it to last 30 years.

That means that if you are earning 11% (as the stock market
has averaged for the last 30 years) and you are 30 now, you
will have to invest $500 each month to achieve this goal.
If you only invest $100 a month you will need an average
return of 18.4%. (If you can average that, you should be
managing the world's money!)

A good financial planner will understand the effects of
inflation and help you plan for them. But I suspect that
some less-trained "planners" (who are probably more like
salespeople in a financial planner suit) tend to "forget",
ignore or don't understand in the first place the effects of
inflation.

Leaving it out of the plan makes the calculations easier and
may even help them get more "sales" because you are not
discouraged by the truth. And their "product" (investment)
may not seem as inadequate as it may really be.

Another quick way to account for the effect of inflation is
to subtract the inflation rate from any rate of interest you
will be receiving on an investment. So if you are going to
assume a 3% inflation rate and the assumed rate of return is
11%, do the projection with only a 8% rate of return or
interest.

This will give you a more accurate picture of the value (not
the amount) of the investment at its maturity.

Some investments such as real estate and precious metals
(gold, silver, etc.) actually benefit from inflation. This
may make you want to truly "diversify" your portfolio into
more types of assets, not just more types of stock.

Inflation does not have to be scary as long as you
understand how it works and how it affects your future money
values. Accounting for it in financial equations and
projections can be done simply. But overlooking it or
downplaying its effects can cause you to miss your financial
goals by a wide margin.