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Monday, November 8, 2010

Is Inflation Over Emphasized?


From time-to-time I'll come across a comment that will just stop me in my tracks. I'll reread it and then it will stick in the back of my mind for days. That happened last week when I read a blog that said financial planners over-emphasize inflation. I read it, reread it, and said huh? I just couldn't understand how a personal finance blogger could think that. To me, it was like someone saying it's OK to sleep on a railroad track.

In the financial planning world, of course, I come across this fairly often. ,People will point out that if they put their money in a 10-year Treasury note, it is perfectly safe and the interest it generates is enough to live on.

Two issues: interest rates change, and the amount of goods the interest payments buy today are a lot more than they will buy in 10 years because of inflation. Let's look back 10 years.

Suppose you retired 10 years ago, put your savings into the 10-year Treasury note and it generated $38,055 in interest payments. Suppose also, along with Social Security and other income sources, you figured this as providing you with a comfortable retirement.

Now move ahead 10 years. What will this $38,055 buy today in terms of goods and services? In other words, what has been the impact of the general rise in prices, i.e. inflation, over the past 10 years?

To answer this, go to the Bureau of Labor Statistics inflation calculator, and put in $30,000 and change the year to 2000. You'll find that, today, the $38,055 will only buy $30,000 in real goods and services - a 21% reduction in buying power! And this in an environment that experienced exceptionally low inflation.

But this isn't the only thing that upset the apple cart. On 1/1/2000 (yipee - Y2k didn't do us in!) the 10-year Treasury note yielded 6.67%. Today it yields 2.54%. Ooch!! Although greatly simplified, this partially illustrates the bind that many retirees find themselves in today.

Today's young people, on the other hand, have lived in a world of low inflation. Maybe most think it's non existent because it has crept up so slowly.

If they listen closely, they will hear their grandparents lament over the fact that the dollar doesn't buy what it once did. This is an expression of inflation.

Henny Youngman put it like this: "The country is getting stronger. It used to take two adults to carry $20 worth of groceries. Today a 5-year-old can do it." This is an expression of inflation.

All of this illustrates the impact of low inflation over a period of 10 years. But what's ahead? Prognostication is (besides not being easy to spell) always tricky, but the fact is that the Federal Reserve has taken the country into uncharted waters. The printing press is running overtime, and banks are filled to the brim with excess reserves. Inflation is caused by an excessive rate of growth in the money supply.

Is inflation over-emphasized? I think not.

2 comments:

  1. To a fixed income investor, inflation is everything-- the difference between real gains or losses. The advantage goes to asset owners, not debt owners, when inflation kicks up.

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  2. The only way inflation would be harmless is if it was spread among everyone perfectly -- everyone's income, savings, and costs rose by an equal amount. Since this isn't how inflation works in reality, there are always winners and losers.

    That extra $8000 in purchasing power that the Treasury holder used to have did not disappear -- it went to someone else. Who it went to is the question we should be asking.

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