What is inflation? How is it measured? And, most importantly, what does it mean for you and your family?
In its simplest form, inflation is the rise in prices of the things we buy. If a 16-ounce steak at your favorite restaurant cost $40 last year and it’s now going for $41, the cost of that steak has inflated by $1, or 2.5%.
There are a number of statistics that attempt to measure how the prices of all goods and services in our economy have risen. The most well known is the Consumer Price Index (CPI). Headline CPI is what is most commonly reported—it incorporates a thorough set of goods and services. Core CPI is headline CPI reduced by the more volatile food and energy components.
CPI—both headline and core—has averaged above 4% for the past 50 years. Core is currently below half of that; headline, which includes the benefit from lower oil prices, is a mere 0.2%.
What does inflation mean for you? For most people, it’s a dual-edged sword. On the one hand, it’s like a tax that reduces your spending power—the same income from last year will buy a slightly smaller basket of goods and services this year. But “slightly” becomes huge when you compound the inflation rate over a long period. For example, 4.1% inflation in the past 50 years means that you’re paying 7.5 times as much for a typical item today than it cost in 1965.
On the other hand, inflation tends to drive up the value of some possessions, such as equities and real estate. Let’s take this a bit further. Inflation is a key determinant of interest rates. When we have low inflation, we typically also have low interest rates. The impact of low interest rates is also dual-edged, because on the one hand, low rates mean you’ll earn very little on savings or other fixed income vehicles. On the other hand, low rates allow businesses to profit more and make more business investments, both of which may translate into higher valuations.
On this latter point, interest rates up to 5% correlate with upward movement in stock prices. Rates above 5% correlate with negative stock market returns.
As you can see, inflation is truly a double-edged sword. Gaining an understanding about how inflation affects interest rates and savings provides insight on the big picture and enables investors to strategize and invest accordingly.
Robert A. “Rocky” Mills is a Financial Advisor with the Global Wealth Management Division of Morgan Stanley in Westlake Village. The information contained in this article is not a solicitation to purchase or sell investments. Any information presented is general in nature and not intended to provide individually tailored investment advice. The views expressed herein are those of the author and may not necessarily reflect the views of Morgan Stanley Smith Barney LLC, Member SIPC, or its affiliates.