Hidden Tax: Inflation and Financial Planning
Sharon L. Secor
October 18, 2007
In recent years, many Americans have come to believe that inflation has become a non-issue. Recent government reports are full of statistics that show inflation at record low levels, approximately 1.1 percent. Omitted from these figures are the cost of items that affect the average person on a very basic level, such as energy and food, despite the fact that inflation is typically defined as the increase in the average prices of the goods and services that you buy day-to-day. The fact of the matter is that inflation is a creeping tax on your assets that must be accounted for in any good financial plan.
The first step in preventing the siphoning away of your net worth by this hidden tax is to understand how inflation affects your savings. Historically, inflation is said to average about 3.1 percent per year, according to official figures, breaking down to just over three cents lost in the value of every dollar you have tucked away for your future needs. While that may not seem like much, multiplying that figure by the 10, 20, or 30 years between now and the time you will use that money certainly sheds a different light on the matter. For instance, a dollar as it was valued in 1950 would only purchase 11 cents worth of goods at today's prices, an 87 percent drop in purchasing power.
Official Inflation Rates: Government Spin and Your Money
The standardized methods used by the government to determine the inflation level can be deceiving. The most frequent measure used to calculate the percentage of inflation in the overall economy is the Consumer Price Index. Compiled by the U.S. Labor Department, Bureau of Labor Statistics, on a monthly basis, these figures are meant to record the average increase of the daily living expenses of typical urban residents. Several versions of this report are released, all based on the same consumer data.
During the early 1990’s, the government began discussions on changing the way inflation rates were officially determined, primarily due to the rising costs of providing mandated Cost of Living Adjustments, or COLAs. These adjustments are made annually to entitlements, interest rates on Treasury Bonds, and other government programs to keep pace with inflation. The goal at the time was to reduce federal deficit spending, and smaller COLAs were seen as part of the solution.
In order to reduce the amounts allotted to COLAs every year, the government needed a lower rate of inflation. Changes made in the data used to measure inflation accomplished that goal - at least on paper. Through statistical manipulation of CPI data, the government managed to reduce the amount of these annual raises, reducing their effect on federal budget deficits.
This was accomplished by the use of so-called Core Inflation Rate reports for official calculations. This compilation of average price increases excludes several key categories, such as food and energy prices. With this new spin on price inflation figures, the rate is determined at a significantly lower level than the actual inflation pressure felt by the average citizen.
For instance, in an October 2007 statement, the Labor Department reported that its Producer Price Index, which reflects the rise in prices before goods reach the consumer, had risen by 1.1 percent in September, more than twice the change that had been expected by analysts. Meanwhile core wholesale prices would give one a much different impression of inflation, since they are compiled with the exclusion of food and energy costs, reflecting a rise in prices of just 0.1 percent. Calculating such basic needs as food and energy into the equation brings one to a figure much closer to the actual rise in living expenses and their effect on the real value of your money.
Even the comprehensive CPI has been manipulated to some degree, the items upon which the price data is collected skewed to show lower inflation rates. By weighting the sample items used to gather data on price inflation towards products and services that are either remaining stable or decreasing in price, and including fewer products with rising prices, the data can be manipulated to the advantage of the federal government, reflecting lower inflation rates in the general economy than may actually be the case. For instance, housing data has been more heavily weighted in the CPI sample basket recently as home values plummet, counteracting the rise in other representative sectors to produce a more favorable overall picture of inflation.
Protecting Your Assets Against Real Inflation
A defense against inflation must be built into the financial planning process if your goal is to maintain the value of your money. Planning your future without taking the slow and steady drain of inflation into account can be a costly mistake. For example, if you are saving for retirement in a simple savings account that yields an interest rate of three percent, not only are you gaining nothing over the long run for collecting that interest, you are still losing a small percentage of the money deposited, even when using artificially low government inflation statistics as your guide. Avoiding the hidden tax of inflation requires that your savings be invested in vehicles that will yield rate of return that is equal to or greater than the rate of real inflation.
In order to choose savings and investment strategies that offer a secure defense against inflation, determining its impact on your investments accurately is essential. Using the average rates quoted by the government is very likely to cause your inflation planning to fall short of its goal in protecting the value of your assets, with a variety of financial experts placing current real inflation at figures as high as 7-10 percent.
For effective financial planning, average inflation figures that reflect real world economic data can serve as reasonable guidelines to use as a starting point. However, it should be noted that everyone spends his or her money a bit differently. For example, the person who commutes long distances to and from work every day will feel the effect of gasoline price inflation in their overall budget much more sharply than the average consumer. Taking stock of the details of your spending habits can help you determine how much your finances are affected by inflation, allowing you to devise a personalized plan to defeat it.
Despite the assurances of government analysts, inflation is a very real problem in today’s economy. The very items that are omitted from the official statistics, food, fuel, and other energy products, are those that affect the financial health of the average American most. When planning your financial future, it is wise to ignore the official spin on the economy and use your own instincts and common sense observations as your guide towards counteracting the insidious creep of inflation.
The first step in preventing the siphoning away of your net worth by this hidden tax is to understand how inflation affects your savings. Historically, inflation is said to average about 3.1 percent per year, according to official figures, breaking down to just over three cents lost in the value of every dollar you have tucked away for your future needs. While that may not seem like much, multiplying that figure by the 10, 20, or 30 years between now and the time you will use that money certainly sheds a different light on the matter. For instance, a dollar as it was valued in 1950 would only purchase 11 cents worth of goods at today's prices, an 87 percent drop in purchasing power.
Official Inflation Rates: Government Spin and Your Money
The standardized methods used by the government to determine the inflation level can be deceiving. The most frequent measure used to calculate the percentage of inflation in the overall economy is the Consumer Price Index. Compiled by the U.S. Labor Department, Bureau of Labor Statistics, on a monthly basis, these figures are meant to record the average increase of the daily living expenses of typical urban residents. Several versions of this report are released, all based on the same consumer data.
During the early 1990’s, the government began discussions on changing the way inflation rates were officially determined, primarily due to the rising costs of providing mandated Cost of Living Adjustments, or COLAs. These adjustments are made annually to entitlements, interest rates on Treasury Bonds, and other government programs to keep pace with inflation. The goal at the time was to reduce federal deficit spending, and smaller COLAs were seen as part of the solution.
In order to reduce the amounts allotted to COLAs every year, the government needed a lower rate of inflation. Changes made in the data used to measure inflation accomplished that goal - at least on paper. Through statistical manipulation of CPI data, the government managed to reduce the amount of these annual raises, reducing their effect on federal budget deficits.
This was accomplished by the use of so-called Core Inflation Rate reports for official calculations. This compilation of average price increases excludes several key categories, such as food and energy prices. With this new spin on price inflation figures, the rate is determined at a significantly lower level than the actual inflation pressure felt by the average citizen.
For instance, in an October 2007 statement, the Labor Department reported that its Producer Price Index, which reflects the rise in prices before goods reach the consumer, had risen by 1.1 percent in September, more than twice the change that had been expected by analysts. Meanwhile core wholesale prices would give one a much different impression of inflation, since they are compiled with the exclusion of food and energy costs, reflecting a rise in prices of just 0.1 percent. Calculating such basic needs as food and energy into the equation brings one to a figure much closer to the actual rise in living expenses and their effect on the real value of your money.
Even the comprehensive CPI has been manipulated to some degree, the items upon which the price data is collected skewed to show lower inflation rates. By weighting the sample items used to gather data on price inflation towards products and services that are either remaining stable or decreasing in price, and including fewer products with rising prices, the data can be manipulated to the advantage of the federal government, reflecting lower inflation rates in the general economy than may actually be the case. For instance, housing data has been more heavily weighted in the CPI sample basket recently as home values plummet, counteracting the rise in other representative sectors to produce a more favorable overall picture of inflation.
Protecting Your Assets Against Real Inflation
A defense against inflation must be built into the financial planning process if your goal is to maintain the value of your money. Planning your future without taking the slow and steady drain of inflation into account can be a costly mistake. For example, if you are saving for retirement in a simple savings account that yields an interest rate of three percent, not only are you gaining nothing over the long run for collecting that interest, you are still losing a small percentage of the money deposited, even when using artificially low government inflation statistics as your guide. Avoiding the hidden tax of inflation requires that your savings be invested in vehicles that will yield rate of return that is equal to or greater than the rate of real inflation.
In order to choose savings and investment strategies that offer a secure defense against inflation, determining its impact on your investments accurately is essential. Using the average rates quoted by the government is very likely to cause your inflation planning to fall short of its goal in protecting the value of your assets, with a variety of financial experts placing current real inflation at figures as high as 7-10 percent.
For effective financial planning, average inflation figures that reflect real world economic data can serve as reasonable guidelines to use as a starting point. However, it should be noted that everyone spends his or her money a bit differently. For example, the person who commutes long distances to and from work every day will feel the effect of gasoline price inflation in their overall budget much more sharply than the average consumer. Taking stock of the details of your spending habits can help you determine how much your finances are affected by inflation, allowing you to devise a personalized plan to defeat it.
Despite the assurances of government analysts, inflation is a very real problem in today’s economy. The very items that are omitted from the official statistics, food, fuel, and other energy products, are those that affect the financial health of the average American most. When planning your financial future, it is wise to ignore the official spin on the economy and use your own instincts and common sense observations as your guide towards counteracting the insidious creep of inflation.
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