One of the most misunderstood topics in all of finance is inflation. If you understand inflation’s real nature, you’ll be leaps and bounds ahead of most economists, financiers, and investors.
The inflation rate is extremely oversimplified by almost everyone — experts and laypersons alike. It’s often seen, for “statistical” reasons, as a single number. Money is either worth more or less every year, and that’s just how it is… according to most economists.
This is devastatingly incorrect. Inflation isn’t static. Inflation doesn’t go up in general — deflation doesn’t increase in general. The reasoning for this is simple, but seems to escape even the most popular financial minds.
Inflation and deflation co-exist.
There’s a raging debate amongst economists around the world as far as what the greatest monetary risk is right now: inflation or deflation? Inflation is where money loses its ability to buy things; deflation is where prices are falling and businesses make less, slowing down the economy.
So, which is the most important? Both are. Inflation and deflation are both dangerous. They’re both happening. Prices are both rising and falling — it just depends on the market. About a week ago, I explained that food and fuel costs were exploding 20-40%. At the same time, it doesn’t take more than a trip to the mall to see clearance signs and racks everywhere — stores are slashing prices to attract buyers, and they’re doing that because sales are extremely slow.
Some prices are extra important.
Economists figure out what the inflation rate is by figuring out how much prices have increased over the course of a year. They get the price data from the core Consumer Price Index, which is put together by the government. This is a simplified understanding, but it works for the purpose of this article.
The problem with this is simple. Because the “index” of prices is simply an economist adding up all the prices and then averaging them out, it’s unavoidable that some products and services will rise more than others. It’s just unavoidable. This is why there’s usually both inflation and deflation going on at the same time, like we’ve talked about before. This means, depending on your spending habits, you could get hit extra hard by inflation — or not too bad at all. It just depends on which prices are skyrocketing and which aren’t.
For example, let’s say food and gas prices double. This probably won’t affect George Soros anytime soon, but for individuals in the middle and lower class who are just trying to earn a basic living, this is a pretty tough situation. I know there were times in my past where if food and gas prices doubled, I would have then gone hungry.
Of course, if the price of TVs and microwaves had doubled, I probably wouldn’t have been affected as much… I wouldn’t have purchased those things, or would have just gone and purchased used ones. But food and energy? Can’t buy that stuff used… I would have been screwed. The consumer price index — how we measure inflation — doesn’t factor food and energy, because the government claims those two areas are too volatile to factor into account. Convenient. In other words, the consumer price index is bull — inflation is really something like 15%+ for most Americans right now, even though they’re reporting it at ~7%.
So, let’s recap: the government is reporting an inflation rate right now somewhere to the tune of 1-2% so far this year. Doesn’t sound bad… except it doesn’t factor into account 20-40% increase in food and energy prices. Oops.
What’s the Real Inflation Rate?.
From a financial perspective, it’s useful to look at inflation like it’s a subjective concept, and not an objective one. The real inflation rate depends on how you spend your money — it’s subjective, not objective.
- Not High. If you spend your money on objects and products that haven’t increased in prices, then your inflation isn’t very high at all.
- Very High. If your budget is relatively small, and food and fuel and other skyrocketing things take up most of the space, then inflation is painful for you — it’s really high.
The real rate of inflation depends on where you are in life. There’s no way around this. Chances are, regardless of who you are, inflation is going to be much, much higher than whatever the government’s reporting. This means you’ll need to find a way to increase your net worth and investments by at least 7-15% per year just to break even.