Inflation
Definition
The rate at which the general level of prices for goods and services rises, reducing the purchasing power of money over time. Measured primarily by the Consumer Price Index (CPI).
Inflation means your money buys less over time. At 3% annual inflation, something that costs $100 today will cost $134 in 10 years. This erosion of purchasing power is why simply saving cash (without investing) guarantees you'll lose money in real terms.
The Consumer Price Index (CPI) is the primary inflation measure, tracking price changes in a basket of consumer goods and services. Core CPI excludes volatile food and energy prices to show underlying inflation trends. The Federal Reserve targets 2% annual inflation as optimal for economic stability.
Inflation profoundly impacts investment decisions. To maintain purchasing power, your investments must earn at least the inflation rate. A savings account paying 4% APY with 3% inflation only provides 1% real return. Stocks have historically returned 7-8% after inflation, making them essential for long-term wealth preservation.
Certain assets perform better during high inflation: real estate (property values and rents rise with inflation), commodities (prices rise by definition), TIPS (Treasury Inflation-Protected Securities, which adjust for CPI), I-Bonds (savings bonds indexed to inflation), and stocks of companies with pricing power (ability to pass costs to customers).
For financial planning, assuming 2-3% long-term inflation is reasonable. This means a retiree needing $50,000/year today will need roughly $67,000 in 10 years and $90,000 in 20 years to maintain the same lifestyle. Accounting for inflation in retirement planning prevents underestimating future needs.
Where this appears in Clarity
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Frequently Asked Questions
How does inflation affect my investments?
Inflation erodes the real value of returns. A 7% investment return with 3% inflation is only 4% in real terms. Cash and bonds suffer most from inflation. Stocks and real estate historically outpace inflation over long periods, making them essential for long-term wealth preservation.
What investments protect against inflation?
TIPS (Treasury Inflation-Protected Securities) directly adjust for CPI. I-Bonds offer inflation-indexed returns. Real estate (rent increases with inflation), commodities, and stocks of companies with strong pricing power also provide natural inflation hedges.