The Consumer Price Index (CPI) is the most common measure of inflation and is determined by totaling the costs of a typical basket of goods and services individuals buy or use. It includes the costs of food, transportation, housing, entertainment, medical care, and more. All totaled the government considers the prices of several hundred items in more than 200 categories.
While the overall inflation rate has been low for the past decade, there have been certain segments of the economy where prices have increased steadily, sometimes dramatically. Medical costs have risen at a double-digit rate, and college costs have increased at a rate about twice the overall rate of inflation.
You must take inflation into account when planning for future expenses, particularly for retirement. Maintaining the financial lifestyle you desire in your retirement years is dependent on how much you have accumulated by the time you retire and how fast you spend those funds during retirement. Inflation rates have been low recently, but there are no assurances the low rates will continue.
Inflation can also affect your investments. Generally, higher inflation or the expectation of higher inflation leads to higher interest rates (lower bond values) and weaker stock prices. When consumers expect things to cost more in the future, they often put less value on their financial assets, and the prices of those financial assets fall.
First, pay attention to the long-term rate of inflation. Inflation cycles tend to be relatively long-term, so if there are a series of monthly inflation rates above the recent 2 to 3 percent level, it could be an indicator of worse things to come.
Second, be sure to consider inflation in your investment planning, especially with respect to your fixed income investments. With interest rates at low levels, it may be advisable to consider shorter or intermediate term bonds (and bond mutual funds) for the fixed income part of your portfolio, even if you have to accept a lower current return. Then if the inflation rate increases and bond values drop, owning shorter-term bonds will moderate the drop in bond values.
Third, factor a realistic inflation expectation into your financial planning. It is probably foolish to expect your cost of living to increase at the recent 2 to 3 percent level throughout your retirement years. The inflation rate is probably more likely to rise over the next several decades than it is to fall. In addition, some of your costs, such as healthcare, will increase as you age.
Inflation is one of the financial facts of life. You cannot control it, and you do not know what it will be in the future. However, you should be aware of inflation trends, factor a realistic expectation into your thinking, and take steps to protect your finances just in case the inflation rate rises.