Monday, May 01, 2006

Inflation - part 1

Inflation is an issue that anyone concerned with planning for their financial future has to think about. It is also an issue that anyone who has to meet their own living expenses has to deal with.

In very simple terms inflation can be used to describe the rate at which prices increase over time. (Yes, I know economists use a different definition and will write about the definition of inflation in part 2 of this article.)

Depending on where you live, inflation in many developed economies has been described as being relatively benign for a period of several years now and typically is said to be around 2% pa. In the US, an increase in the inflation rate to slightly above 3% pa has largely been blamed for the series of interest rate rises implemented by the Federal Reserve.

An inflation rate of 2-3% pa may not seem like much but it can have a significant effect on the value of savings over time. An inflation rate of 2% pa over 20 years effectively reduces the value of savings by about 32%. An inflation rate of 3% pa over 20 years reduces the real value of savings by 44%. This is huge!

One of the implications of an inflation rate of 2-3% pa is that, if the inlflation rate is 2-3% pa, then savings have to earn 2-3% pa after taxes and expenses just to break even. Currently, bank deposits and bonds more or less do this but fail to generate a meaningful rate of return. Put differently, deposits and bonds just do not provide an accepetable rate of return and, over the longer term, can only be viewed as a temporary place to park money pending the search for a more suitable investment.

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