Ugh…Inflation! No one seems to like it but what does it mean? How can we measure how much purchasing power we’re losing due to inflation? Questions such as these and more are answered in this post.
Inflation is the rate at which the general level of prices for goods and services rises, eroding the purchasing power of money. It affects everyone, including common folks like us, in various ways. As inflation increases, the prices of everyday items like groceries, gasoline, and housing go up. This means you need more money to buy the same goods and services. That also affects the long-term future because the money saved in a bank loses its purchasing power over time if the interest earned on savings is less than the inflation rate.
What about the wage increases? If cost of goods rise Ideally, wages should increase with inflation, right? Yes, but this doesn’t happen often. Even if wages increase, as businesses face higher costs for labor and materials, they are inevitably passed on to consumers through higher prices leading to net increase of purchasing power due to higher wages.
Without going further into the complexity of this economic phenomenon, my chart above lays it all out in simple terms. It answers the basic, practical questions at a give inflation rate:
1) By how much is my money losing value year after year?
2) How much money would I need to purchase the same amount of good in the future (say, after x years)?
Hover over any datapoint on the chart above to see more information.
Assumming a 4% average yearly inflation rate, we find that the goods we get for $1 today would require about $2.77 in 25 years. Or, put another way, a $1 would only buy you $0.36 worth of goods in 25 years (circa 2050).
The 4% rate is of course an assumption as the inflation rates vary over time due to different economic conditions, policies, and global events…sometimes wildly! Look at how the have fluctuated in the past 20 years in the USA. The inflation rate was negative in 2009 (at -0.4%) — there was definitely a deflation! This happened during the global financial crisis when there was a significant reduction in demand, leading to a decrease in prices. In 2015, the inflation rate was very low at just 0.1% due to low energy prices and a strong dollar, which kept prices for imported goods low. And it hit a peak of 9.1% in June 2022 (the chart shows overall year’s rate, not monthly, which translated to 8.0% for the year).
How are these calculated and built?
Data was collected from U.S. Bureau of Labor Statistics. The purchasing power and YoY decrease in value and how much a $1 would buy in a number of years is calculated using the using Future Value concept which is: present value / purchasing power after n years. The purchasing power at a given year is calculated each subsequent year starting from the initial value (in this case, $1) by: previous value – (previous value * inflation%). The YoY change in value is the difference between previous year’s purchasing power and current year’s purchasing power.
All this was set up in Excel and calculated for the number of years desired (in the above example, 25 years, meaning, 25 rows of data and calculations). For exemplification, 4% inflation rate was applied uniformly across the range of years presented. If each year’s future inflation rate was known (which is not possible with 100% accuracy), each year’s purchasing power would be calculated applying that rate for the corresponding year. A Line chart with two series was created for the first chart in Excel. However, to make it embeddable, interactive (and apply the animation), and responsive across devices, chart.js engine was used. For example, you can hover over any datapoint on the charts to get more information.
The data on inflation history required no calculation as U.S. Bureau of Labor Statistics publishes the historical rates, which were then simply charted as a Line chart and embedded using chart.js.
A word about inflation, interest, and hedging
While I’m not a financial advisor, some strategies that are commonly suggested by professionals to cope with inflation (other than just being wealthy!) are:
– Track your spending and adjust your budget as needed to account for rising prices.
– Consider investing in assets that can provide returns above the inflation rate. Inflation often leads to higher interest rates, which increases the cost of borrowing for mortgages, loans, and credit cards, which can also mean opportunities to get higher returns on savings accounts and fixed deposits.
– Work with a professional financial advisor to develop strategies that protect your savings and investments from inflation.
Generally speaking, when inflation rises, interest rates rise, CPI (consumer price index) rises, stocks decline, government bonds (TIPS, I-Bonds), and commodities investments (gold, silver, oil, etc.) rise. Central banks may raise interest rates to control inflation. And reverse is generally true. Central banks may lower interest rates to stimulate economic growth. Traditional bonds can benefit from lower interest rates, which increase their prices (while TIPS, I-Bonds are trend in opposite direction). These trends often hold true but not guaranteed however.
I hope this was educational and interesting. Happy exploring!
