The Importance of Taking Inflation into Account

There are lots of reasons to try to grow your wealth, from retirement to education to starting a business. One thing these goals have in common is that the amount of money needed to achieve them doesn’t stay constant. The prices of almost everything change over time, which is why it’s important to take inflation into account when setting your financial goals.

The inflation rate (typically measured using the Consumer Price Index) reveals how much prices have risen (or fallen) on average for the things consumers spend their money on, such as food, rent, clothing, and medical care. If prices increase, your “purchasing power” falls, since the same amount of money can buy fewer items. Over long periods of time purchasing power can change dramatically: you would need almost $2,400 to buy the same amount of goods and services that you could have bought with $100 a century ago.

When “inflation” is discussed as a general concept, it’s referring to this average price increase. For specific items, however, price increases or decreases can be substantially different. According to the College Board, for example, since 1971 the average cost of college at a private non-profit four-year school increased by 2.1% per year more than the overall inflation rate.

College Costs

So how much inflation should you plan for when setting your financial goals? There’s no universal answer. The Federal Reserve, which controls interest rates to manage economic growth and inflation, aims for a 2% inflation rate. For a broad goal, such as retirement, this number is probably a reasonable assumption. For goals more focused on a specific purchase—such as funding a college education or buying a home—the right inflation assumption will depend on the details of the goal, and could be much higher or lower than 2%.

Topics: Blog Inflation College Retirement