Week 9 Day 1: Your Money Is Shrinking Right Now

At 3% inflation, $100 today buys only $74 worth of stuff in 10 years. Your bank balance says $100, but its purchasing power has dropped by 26%. Inflation is a tax that nobody votes for and everybody pays. The only defense is investing at rates that exceed inflation.

The U.S. has averaged roughly 3% annual inflation over the past century. That sounds benign -- and year to year, it is. You barely notice a 3% price increase on any single item. But compounded over decades, it is devastating. At 3% inflation: $50,000 in today's dollars buys only $37,000 worth of goods in 10 years. $27,600 in 20 years. $20,600 in 30 years. A retiree who needs $50,000/year at age 65 will need $67,000/year at age 75 and $90,000/year at age 85 just to maintain the same lifestyle. This is why 'I need $1 million to retire' is a statement that needs a year attached to it. $1 million in 2024 is very different from $1 million in 2054. At 3% inflation, you will need $2.4 million in 2054 to have the same purchasing power as $1 million today.

Inflation is measured primarily by the Consumer Price Index (CPI), calculated monthly by the Bureau of Labor Statistics from a basket of roughly 80,000 goods and services. However, CPI has been critiqued on multiple fronts: (1) it uses hedonic adjustments that may understate felt inflation (e.g., a computer costs the same but is 'better,' so CPI says it got cheaper), (2) it may not reflect individual inflation rates which vary by spending pattern (medical inflation has historically exceeded headline CPI by 2-3%, meaning retirees face higher effective inflation), and (3) housing costs are measured via 'Owner's Equivalent Rent' rather than actual home prices, which can diverge significantly. The Federal Reserve targets 2% inflation as measured by the PCE (Personal Consumption Expenditures) index, which differs slightly from CPI. For personal financial planning, using 3% as your assumed inflation rate provides a reasonable margin of safety.