Inflation and Purchasing Power

What inflation measures

Inflation is the rate at which a defined price index changes over time. Statistical agencies build indices from baskets of goods and services with assigned weights. Different indices can produce different rates because they cover different populations, use different formulas, or treat housing and other categories differently.

A published inflation rate is therefore not the exact increase in every household's cost of living. Someone who spends heavily on categories rising faster than the index may experience greater personal cost pressure; another household may experience less.

Nominal and real values

Nominal values are expressed in the currency amounts of the period. Real values adjust for changes in purchasing power. If an investment grows 5% while the relevant inflation rate is 3%, the approximate real growth is smaller than 5%. The precise real-return formula is (1 + nominal return) divided by (1 + inflation) minus 1.

For long-term goals, it is useful to show both. A future portfolio balance may look very large in nominal terms but support less spending than the same number would today.

Inflation and cash flow

Inflation affects expenses unevenly and can also influence wages, interest rates and asset prices. Higher inflation does not guarantee that income rises at the same pace. A robust plan tests what happens if essential spending grows faster than expected for several years.

When modelling a goal, be consistent. Either project future costs in nominal terms using an inflation assumption, or convert future portfolio values back into today's purchasing power. Mixing nominal asset growth with today's unadjusted costs can overstate affordability.

Use ranges

Inflation is uncertain, so a single long-term rate should be treated as a scenario. Compare several rates and pay attention to the goals that are most sensitive to purchasing-power erosion.