According to the government’s figures, inflation was a modest 2.7% over the twelve months ending in March. The Consumer Price Index (CPI) is the Bureau of Labor Statistics’ popular measure of economic changes affecting typical consumers in the United States. It’s a figure we often compare to after-tax savings interest rates, reminding us that our funds locked safely away in FDIC-insured banks are losing real value every day. Even supposed high-yield savings accounts are no match for the government’s figures.
This comparison doesn’t make sense on an individual level because the CPI is not an individual measure. Overall, we can look at the economy and see that an increased number of people who are saving and the increase in savings account balances coinciding with a bigger spread between the interest rate earned after tax and the CPI can be bad, but any individual cannot use this information to make financial decisions.
The Saver’s Dilemma is that as a whole, we tend to save more when it’s less financially advantageous, avoid debt when it’s cheap, and spend recklessly when we would be rewarded for saving. Furthermore, the government’s numbers hide the reality that individuals deal with. Personal rates of inflation are often much higher than official statistics, due partly to limitations in the calculation and partly to individual spending patterns. It helps to remember than savings accounts are primarily for cash that you need within a year, including an emergency fund, so the interest rate should be mostly irrelevant.
Here’s a rundown of some of the flaws or limitations of the Consumer Price Index:
- CPI focuses on urban consumers. Rural consumers may have different experiences that are not reflected in the calculation. This may help to hide price increases that millions of Americans experience due to rural reliance on transportation, for example.
- The components of the CPI, such as food and energy, are weighted. The price of food and beverages comprises 14.792% of the CPI while medical care is weighted 6.627%. These percentages might not reflect any individual’s spending patterns.
- The sample ages differently than any individual. Forgetting the concept of emotional age, individuals age linearly. Each year you will be one year older than the last. The change in your income, for the most part, increases with your age. The age of a population sample does not progress in a straight line. For example, baby booms can skew the average age downward from one year to the next, when those babies are old enough to become part of the sample.
- Personal desires become needs. Over time, the middle class has become better off. It was once a luxury to own a television sets; now households often own two or three high-definition TVs and several computers. The standard of living has increased and what it means to “get by” has changed. This is an overall observation, but it might apply to you without being reflected in the CPI.
These limitations make it difficult for you to calculate your real return. Convention calls for subtracting the inflation rate from your investment return to determine your “real” rate of return. That may be fine for comparing your performance with other possible investments, but it doesn’t provide a true understanding of how your purchasing power has changed. Your purchasing power depends entirely on what you purchase.
Look at your real expenses. This is easy to do if you track your spending. How much do your expenses change from one year to the next? Your personal rate of inflation may be much higher than the CPI for a number of reasons:
- You have more money to spend.
- Your tastes change and you want better quality products.
- You were hit with major one-time expenses.
- Your children are getting older.
While you may be getting more for your money in some areas, you’re not in others. Food prices may increase, but if you have three mouths to feed this year when a year ago you had only two, the effect of the price increase will hit harder. If your company moves to a new location twice as far from your home as last year, the increase of the price of fuel is more damaging to your finances than the CPI would indicate. While your $2,000 computer today will be more powerful than a $2,000 computer last year, it still serves the same functions.
Silent inflation — the increase of the cost of your particular mix of expenses and the change in your spending behavior — is what is destroying your net worth. There’s no investment that sufficiently fights this type of inflation. There are two proven strategies:
- Spend less money. Consciously controlling your expenses and cutting back on certain expenditures can reverse the effect of your personal inflation. Obviously not a popular approach except among the terminally frugal, almost everyone can find ways to shave the top off their expenses. David Bach, who created the Latte Factor, talked with Consumerism Commentary about options for individuals who already cut their expenses as much as possible but still wanted to save their finances.
- Earn more money. You can only cut your expenses to a point — the point at which you are spending only on necessities for life. Once you reach that point, earning more is the only option. Even when you have more to cut, you can benefit from earning more. Although a penny earned is not worth as much after tax as a penny saved, the possibilities for increasing income are limited only by your time and your willingness to learn new skills and take on new projects.
Often, people suggest investing in assets that produce revenue, like rental properties, as a way to put yourself on the better side of inflation. Aside from the risk involved with any type of investment, the benefit might not be so great. If you can increase the rent with the increase in the CPI, for example, you will increase revenue to the landlord, but the landlord’s expenses will also increase. Raising rents may not be pure profit.
Calculate your personal rate of inflation by comparing expenses from the past 12 months to your expenses from the 12 months prior. Did the expenses increase? If so, are you living better off than you were in the previous year or does the increase not reflect any substantial changes in your lifestyle?
Published or updated April 27, 2011.