Making Cents: Inflation may be different than you think
By: John P. Napolitano, CFP®, CPA, PFS, MST
When following headline news about the economy, we hear stats about unemployment, GDP, Financial markets and the rate of inflation. You’d think that with all of the data and technology available today that these statistics are accurate and understandable. But the published inflation rate isn’t that simple and has limitations when it comes to using it as your guideline for forecasting your cost of living during retirement.
If you’ve been to a building supply store lately, you may have noticed that some prices have soared in the last few years, particularly the past few months since the onset of COVID-19. That along with the rising prices for a few other necessities such as food, housing and used cars, and some may logically ask if inflation has kicked up a notch.
The annual inflation rate for the United States is 1.4% for the 12 months ending September 2020 as compared to 1.3% previously, according to US Labor Department data published on 10/13/2020. How much has your home appreciated in the past year alone and why isn’t that reflected in the recently published statistics?
Since the mid 1980’s, home ownership isn’t reflected in the calculation of inflation. Policy makers decided that rent is a steadier barometer of housing cost inflation because rent is truly money spent. Their theory is that home ownership, while entry points may fluctuate, are assets you own that are consumed over a longer period with residual value. If home ownership was included, its inflationary impact today would likely be dampened in that most Americans will also borrow at record low rates driving down the cost of ownership.
Another little known fact about inflation’s formula is that quality improvements are excluded from the calculation. This sounds confusing, so here’s an example to explain how this works. Suppose you want to buy a new food processor for your kitchen. You look online and see model #1 priced at $100. You decide to hold off, and a year from now your old one breaks and you decide to buy a new one. Except this year, model #2, is priced at $110. You’re thinking that the rate of inflation for this item was 10% due to the 10% price increase. But that may not be true.
You didn’t realize that model #2 had a few improvements that may indeed make it better, even if you didn’t want or need them. #2 has better choppers, blades and electronics that add up to $10 worth of improvements, hence the $110 price tag. That $10 will be excluded from the inflation calculation, and the calculated rate of inflation for this item will be recorded as 0. This is because the entire price increase was caused by improvements.
Over an extended period, underestimating the rate of inflation by 1-3% may make a material difference to you depending on how much you’ve saved and how much risk is in your portfolio. Use a higher inflation rate as one of your stress test points, and see what happens.
John P. Napolitano CFP®, CPA is CEO of US Wealth Management in Braintree, MA. Visit JohnPNapolitano on LinkedIn or uswealthnapolitano.com. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. John Napolitano is a registered principal with and securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through US Financial Advisors, a Registered Investment Advisor. US Financial Advisors and US Wealth Management are separate entities from LPL Financial. He can be reached at 781-849-9200.