Inflation's effect on long-term purchasing power

In short

A friend of mine keeps a jar of quarters on his dresser, and he says it is his rainy day fund. He means well, and he works hard for that money. But a dollar sitting still buys a little less each year, and that fact is worth knowing. Prices rise over time, and economists call that rise inflation. Money you do not spend today will buy fewer things when you finally do spend it. The cure is not panic. It is simply to know the rate, do the arithmetic, and compare what your savings earn against what prices are doing.

The whole of it

What it is

I once watched my grandfather hold up an old movie ticket stub and laugh about what it cost. A nickel, he said, and popcorn thrown in. He was not complaining. He was just noticing, the way a farmer notices the weather. That is a fair way to think about inflation. It is the slow rise in the price of the things we buy, and it never takes a day off.

When prices go up, each dollar buys a smaller share of the groceries, the rent, and the gasoline. We call that purchasing power. It is a plain idea. It asks how much stuff one dollar can carry home. A small rise in prices each year feels like nothing. Over a working life, it feels like a lot.

In the United States, the Bureau of Labor Statistics publishes the Consumer Price Index, which tracks what households pay for a basket of everyday goods and services. It is the number most people point to when they talk about inflation. It is not perfect, and no single number could be. Your own costs may rise faster or slower than the average, depending on where you live and what you buy.

How it works

If you are saving for something far off, like retirement or a child's schooling, this matters to you more than you might think. Your dollars are not just sitting there. They are slowly shrinking in what they can do, unless something offsets it.

Here is the mechanism in plain terms. Say prices rise 3 percent in a year. A basket of goods that cost $100 last year now costs $103. If your savings account paid you nothing, you can still buy only what $100 bought, and that now falls short of the basket. If the account paid you 3 percent, you broke even. If it paid less, you fell behind in real terms.

The gap between what your money earns and what prices climb is called the real return. It is the number that tells you whether you are gaining ground or losing it. A bank may advertise a rate, and that rate is real money. But the rate that matters for your future is the one left after prices are taken out.

Time makes the effect bigger, the way a snowball picks up more snow the longer it rolls. A 3 percent rise each year does not add 3 percent twenty times. It compounds, meaning each year's rise builds on the last. That is why the long run surprises people.

The numbers, and where to find yours

You can find the official inflation figures for yourself, and I would encourage it. The Bureau of Labor Statistics, part of the Department of Labor, publishes the Consumer Price Index on its own website, with a calculator that lets you compare prices between any two years. It is free, and it is the primary source, so you are not relying on someone's say so.

The Federal Reserve also states an inflation goal. Its stated target is the current figure, which the official source publishes each year, and you can read its own words about that goal on the Federal Reserve Board website. The latest reading of the index moves from month to month, so the site fills in the current figure at the current figure, which the official source publishes each year along with its source and date.

For your own situation, write down two numbers. First, the interest rate your savings earn. Second, the inflation rate from the sources above. Subtract the second from the first. That small piece of arithmetic is your real return, and it tells you more than the advertised rate ever will.

A worked example

Let me tell you about a woman I will call Margaret. She is 40 years old and has set aside $10,000 in a drawer account that earns nothing. She plans to touch it in twenty years. She figures that $10,000 will still be $10,000, and she is right about the number. She is wrong about what it will buy.

Suppose prices rise 3 percent each year, which is a round figure for this story and not a forecast. After one year, the price of her basket is 1.03 times what it was. After twenty years, it is 1.03 multiplied by itself twenty times. That works out to about 1.806. So a basket that cost $10,000 today would cost about $18,060 in twenty years. The check is 10,000 times 1.806, which is $18,060.

Turn it around. Her $10,000, untouched, would buy what $10,000 divided by 1.806 buys in today's money. That is about $5,537. Her dollars are all still there. But they carry barely more than half of what they carry today.

Now suppose Margaret instead earned 3 percent a year on that money. After twenty years, $10,000 grows to 10,000 times 1.806, or $18,060. The price of her basket is also $18,060. She stays even. Her purchasing power holds. And if she earned 5 percent, $10,000 times 2.653 is $26,530, which is $8,470 ahead of the $18,060 basket, in the same future dollars. That gap is her real gain.

No judgment in any of this. Margaret is no fool. She simply had not run the numbers. Most of us have not.

Where it goes wrong

I have made my share of mistakes with money, so I speak as a fellow traveler. The first slip is trusting the number on the statement. It feels solid. Your balance says $10,000, and it stays $10,000. But a steady balance can hide a shrinking ability to buy.

The second slip is using the wrong rate. The average inflation figure is only an average. A retiree who spends heavily on health care may feel prices rise faster than the headline number. A young renter in a pricey city may feel the same. The official index measures a typical basket, and yours may differ.

A third slip runs the other way. Some people grow so afraid of inflation that they chase high returns without counting the risk. That can cost them more than inflation ever would. Higher potential returns come with a higher chance of loss, and the loss is real. I am not telling anyone what to buy. I am only saying that fear is a poor planner.

Taxes matter too. Interest you earn can be taxed, so what you keep after tax is smaller than the advertised rate. A 3 percent return taxed at 25 percent leaves you 3 times 0.75, which is 2.25 percent. If prices rise 3 percent, you have lost ground even though the account grew. Check the tax rules that apply to you with the Internal Revenue Service, since they differ by account type and by person.

Questions to answer before you leave this page

What rate does your savings account pay right now, and have you written it down? What is the latest inflation figure on the Bureau of Labor Statistics website, and how far apart are those two numbers? If you subtract one from the other, are you gaining ground or slipping behind? How many years until you will need this money, and what would a rise of 3 percent a year do to its buying power over that span? Do your own costs, such as rent, food, or health care, rise faster than the average basket? And after tax, what do you actually keep from what your savings earn?