By: Lyn Alden
When you research an investment and its expected rate of return, one of the most important things to keep in mind is how it compares to inflation.
For example, the TSP G Fund gave investors 2.33% returns in 2017, but the U.S. inflation rate averaged about 2% that year. Your real inflation-adjusted rate of return was therefore just a fraction of a percent. Virtually all of the returns were balanced out by higher prices on consumer goods, rather than giving you a real increase in your purchasing power.
The Federal Reserve specifically aims at about 2% inflation per year:
“The Federal Open Market Committee (FOMC) judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve’s mandate for price stability and maximum employment. Over time, a higher inflation rate would reduce the public’s ability to make accurate longer-term economic and financial decisions. On the other hand, a lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling–a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken. The FOMC implements monetary policy to help maintain an inflation rate of 2 percent over the medium term.”
With that in mind, here’s a chart of the U.S. inflation rate over the past five years:
Banks are currently paying savers about 1.5% on average, which means your bank savings are slowly losing purchasing power. You can push your bank rates up to about 2.5% if you lock your money into a certificate of deposit, and therefore just maintain (rather than grow) your purchasing power. This is part of the reason that stocks are so highly-valued now; due to low interest rates investors have been forced into riskier assets if they want meaningful returns, and that could end in a troublesome way.
And if you look outside the country, you can find more extreme examples. My relatives in Egypt currently invest in bonds that pay 20%+ in annual interest, which sounds incredible at first. But since the inflation rate for the Egyptian pound has been about 15-30% over the past year, this immense rate of return is just treading water on purchasing power.
The United States has experienced this in the past. Inflation on the U.S. dollar reached double digits in the 1980’s, and a number of times before that as well:
The net result of this is that an item that cost $25 in 1950, or $100 in 1983, costs $250 today:
This is why it’s important to keep inflation in mind when investing and planning for retirement. If you have a plan to reach $1 million in net worth over the next 25 years, for example, it will really only be worth about half of that in terms of purchasing power.
If stocks return 7% per year on average while inflation is 3%, the real rate of return on purchasing power is 4%. If bonds give you 3% returns while inflation is 2%, your net result is just about 1% in real gains.
Here’s a chart I made a couple years ago that shows how much inflation-adjusted wealth you can build with a given monthly investment (vertical axis) and a given annual average rate of return (horizontal axis), assuming 2.5% annual inflation, with values over one million highlighted in green:
(Click for a bigger image.)