Purchasing Power Risk

For the first time in nearly four decades, top news stories over the last year have regularly been about inflation. Inflation is the rise in prices of goods and services. Conversely, deflation is the general decline in prices. Over time, inflation slowly (or sometimes quickly) erodes purchasing power. This is known as purchasing power risk. Think of it this way: How much would the same $20 bill purchase today versus 30 years ago? Simply put, rising prices means the same Andrew Jackson green-back buys less over time. We should first acknowledge purchasing power risk but then take steps to mitigate this risk.

On a monthly basis the United States government, through the Bureau of Labor Statistics, measures and publishes inflation data. This statistic known as the Consumer Price Index (CPI) measures the change in price paid for goods and services by the average U.S. consumer such as food, energy, transportation, housing and medical service. The CPI published in mid-December 2022 shows that prices increased over the last 12 months at a rate of 7.1%1.

Your personal inflation rate may be more or less than actual CPI. For example, the government’s report on CPI attributes just over 30% of total household costs on shelter (rent, housing) while it attributes about 8% of total household costs to medical care2. Perhaps a younger person with little medical expenses, but higher level of housing rent, would proportionally be impacted much greater by rent increases than an older person with a paid for mortgage but higher degree of medical care needs.

Slower inflation rates still erode purchasing power over time. Even a 3% inflation rate means the cost of goods and services will double in price in 24 years3.

Over the last year, the Federal Reserve has been increasing interest rates (through the federal funds rate) to increase the cost of money to try to slow down inflation. This rise in interest rates has impacted borrowing costs with the idea that consumption would be slowed with a higher cost of money.

To combat purchasing power risk we should keep our incomes growing at least at the rate of inflation. Traditionally, “owing” inflation has been a good hedge against inflation. Income producing real estate or high quality dividend paying companies tend to pay more to investors over time. For retirees collecting social security, it is important to acknowledge that social security has a yearly cost of living adjustment which will increase payments over time to keep pace with inflation.

Fixed rate investments, such as bonds, tend to be susceptible to purchasing power risk. For example, a fixed rate bond paying $500 interest per year will continue to pay that interest over the duration of the bond, absent default. However, the yearly $500 interest payments will purchase the owner of the bond less and less goods and services over time due to inflation.

While inflation has not been a hot topic since the early 1980s, we should recognize purchasing power risk and take steps to mitigate this risk over time.

Adam Smit is CERTIFIED FINANCIAL PLANNER™ and a registered principal of LPL Financial. This article is for general information only and not intended to provide specific advice or recommendations for any individual. Dividends and interest income are not guaranteed. Securities offered through LPL Financial. Member FINRA/SIPC.

1- https://www.bls.gov/news.release/cpi.nr0.htm 2 – https://www.bls.gov/cpi/tables/relative-importance/2021. htm 3 -“Rule of 72”; 72 / 3% = 24 years

BY ADAM SMIT