One of the observations I have from creating projections for funding future goals such as college or retirement is that it is often very hard for clients to understand the impact of inflation. So, I decided to write a two-part blog about inflation. Part One covers the causes of/and multiple definitions for inflation. Part Two discusses the risk and impact of inflation, because we are living longer.
What causes inflation?
There are several possible answers. The recent damage caused by Hurricanes Harvey and Irma and California wild fires results in higher prices because there is a temporary shortage of goods. Therefore, prices are bid up as people compete to obtain what they need. Fortunately, these situations are temporary. Inflation is also caused when businesses purposefully restrict supply thereby artificially raising prices. This happened in the 1970’s when OPEC agreed to limit oil production in an effort to increase oil prices.
The primary cause of inflation is an increase in the money supply. You have probably heard the phrase, “Too much money chasing too few goods and services increases prices.”
What is the difference between inflation and the Consumer Price Index (CPI)?
The CPI is an index… or “a number used to measure change”. It measures the change in prices paid by consumers for goods and services. It reflects the spending patterns of urban wage earners, consumers and clerical workers. Interestingly, the CPI does not include the spending habits of people living in rural (non-metropolitan) areas, people in the Armed Forces, and anyone incarcerated or a patient in a mental institution. (Source:InflationData.com)
Price Inflation (what we simply call inflation) is the “percentage increase in the price of the basket of goods and services over a specific period of time”.
The key to this definition is knowing what is in the “basket” that is being measured.
Interestingly, it is “all items less food and energy”. This means the basket includes goods and services such as transportation, medical care, vehicles, clothing, and housing.
Barbara A. Culver
CFP®, ChFC®, CLU, AEP®