Tuesday, March 15, 2011

100 Years of Inflation Rate History

Inflation can be devastating; while it has been under control for the past 25 years, there is no guarantee that it will remain so. Since this blog emphasizes long-term planning, it is important that we address the issue of inflation, and the impact that the declining purchasing power of the dollar has on our investments. For perspective, as always, let's first look at the past century.

U.S. Inflation Rates since 1900

Yearly change in consumer price index (CPI-U) 1900-2012
U.S. Yearly Inflation since 1900

The above chart shows the yearly rate of inflation as measured by the Consumer Price Index for All Urban Consumers (CPI-U) for the past 100 years. By early 2012, prices were more than 28 times higher than in 1900 -- the CPI increased from 7.9 to 226.7. Phrased differently, a dollar buys 28 times less now than a dollar bought in 1900 (see inflation calculator). While inflation has averaged only 3% for the complete period, and also 3% since 1982, such subdued inflation has clearly not always been the case. The graph shows several periods where inflation rose to 10% or more. Here's a quick summary of inflation's impact on some key areas.

The Impact of Inflation: A Dollar Buys a Lot Less Than it Used To

Inflation increases the
price of the things we buy. When I first started driving, gasoline was 25 cents a gallon; now it's more than $3/gallon -- more than 10 times higher. On the other hand, salaries are also more than 10 times higher; if not, few people could afford food or housing, or gasoline. As a result, you could argue that the ultimate net impact of inflation on income and expense for working people is relatively small. (However, it can be painful since increases in salaries often lag behind inflation. In addition, unless/until tax brackets are adjusted, it pushes taxpayers into higher tax brackets). Partly for that reason, in this post I'll focus on the impact on assets. (Note: To see just how much less a dollar buys than it used to, see The Declining Value of the U.S. Dollar.)

The Rule of 72 & the Impact of Inflation on the Value of a Dollar

The rule of 72 says that if inflation is N%/year, prices will double in approximately 72/N years. For example, at 3% inflation, prices will double in (72/3=) 24 years; at 12% inflation, prices will double in (72/12=) 6 years. This means that at 3% inflation, the purchasing power of a dollar will be cut in half every 24 years; since what you could buy for $100 will cost $200 24 years later, the value of the original $100 has effectively been reduced by 50% -- to $50.

Inflation Hurts Savers and Helps Debtors!

As a result, inflation can be devastating to people with a lot of cash; the higher the rate of inflation, and the more dollars one holds, the more devastating is the impact. It follows (though somewhat surprisingly to some) that inflation is a boon to those with negative assets -- i.e., those who are in debt; and, the more inflation and the more debt, the bigger the benefit! If you have huge student loans that you have no idea how you will ever repay, pray for inflation. You want to repay those loans with cheaper dollars -- dollars with less purchasing power than today's dollars.

The Impact of the Rate of Inflation on Bonds

Inflation affects conventional, non-inflation-protected, bondholders in three ways. First, the purchasing power of the periodic interest payments decreases with time. Secondly, at maturity, the principal repayment that they receive is in cheaper dollars -- dollars with less purchasing power. Finally, increasing inflation generally means higher interest rates, which in turn means lower prices for bonds they currently own.

The impact of these factors increases as inflation increases and as maturity/duration increases. To offset inflation, bond buyers generally demand higher rates for longer maturities, and when inflation is high or rising. The problem arises when inflation rates are higher than was anticipated at the time the bond was purchased. (For a more complete discussion, see posts on inflation-adjusted 10-year Treasury note returns, and why rising interest rates cause falling bond prices.)

The Impact of Inflation Rates on the Stock Market

The conventional wisdom is that stocks are the best protection against low to moderate inflation (~0-6%); over long periods, under "normal" circumstances, the equity asset class has generally outperformed all other asset classes. At inflation rates above 6% or so, there is some evidence that natural resources, real estate and commodities (e.g., gold) perform better than equities -- in some cases much of the out-performance comes in anticipation of inflation. (See 100 Years of Inflation-Adjusted Stock Market History: note especially what happens during periods of high inflation.)

The Impact of Inflation Rates on Housing

Homeowners with mortgages are debtors. As a result, the larger the (conventional, fixed rate) mortgage, and the more years remaining, the larger the benefit (see "Inflation Helps Debtors" above). In the U.S., the fact that the mortgage interest payments are tax deductible enhances that benefit.

At the same time, the value of the home is likely to appreciate at least in line with inflation (see 100 Years of Inflation-Adjusted Housing Prices), and real estate tends to outperform equities during periods of high inflation. In the U.S., the value of the gain will be enhanced by the fact that taxes on the gain are deferred until the sale, and much of the gain may be exempt from taxes. Finally, the return on investment is magnified by leverage -- the home buyer receives all of the appreciation in price even though his equity in the home is less than 100%. (See The Problem with Low Down Payment Mortgages for more on the impact of leverage).

The Impact of Inflation on Retirees & Retirement Planning

...can be devastating. The tremendous spike in inflation in the late 70s had relatively little impact on my lifestyle. I was young, employed, and my accumulated savings were relatively small. However, in general, retirees are in the opposite position. They have the most cash and bonds, and therefore have the most assets at risk. In addition, many retirees have income streams that are not adjusted for inflation -- such as corporate pensions and fixed annuities. Even if the inflation rate averages only 3%, prices double in 24 years, and the purchasing power of their income will be cut in half. Inflation is one of the most critical challenges for retirees. (See How Much Will $100 be Worth in 10-20 Years?)

Retired homeowners will benefit from the appreciation in the value of their homes. However, they may not benefit as much as younger homeowners because younger homeowners tend to have more mortgage debt, and more leverage. In addition, inflation increases ongoing home ownership expenses. Retirees with significant non-inflation-adjusted fixed income may have trouble keeping up with increases in real estate taxes, insurance & home maintenance costs.

Caveat: Think Both Nominal AND Real Growth

Low to moderate inflation is generally relatively benign -- especially if planned for. However, even these levels can cause investors to significantly overestimate their performance over long periods of time. For example, a stock or real estate investment that has doubled in 24 years during a period of 3% inflation has only maintained its purchasing power. On the other hand, that would clearly be better than investment alternatives that lost purchasing power....

Related Material

The Declining Value of the U.S. Dollar: Graphs cumulative change in value since 1900.

How Much Will $100 be Worth in 10-20 Years? Graphs the impact of inflation rates of from 1-10% on purchasing power over the next 1-50 years.
Inflation Calculator/Spreadsheet: calculates inflation rates between any 2 years, and converts dollars to equivalent purchasing power.
100 Years of Treasury Note Real Return History -- to see inflation-adjusted treasury yields.

100 Years of Inflation-Adjusted Housing Prices -- to see inflation-adjusted housing prices.
100 Years of Inflation-Adjusted Stock Market History -- to see how the stock market reacts to inflation.
About Nominal & Real Rates of Return: discusses the difference between real & nominal returns.
Wikipedia: for a more detailed discussion of inflation and the rule of 72.
For an even more detailed discussion of inflation and the CPI, see this article.
For lists of other popular posts and an index of stock market posts, by subject area, see the sidebar to the left.

Pre-1913: Robert Shiller "Irrational Exuberance" data
1913 forward: Consumer Price Index for All Urban Consumers: All Items (CPIAUCNS) from the U.S. Department of Labor: Bureau of Labor Statistics.

Copyright © 2011. Last modified: 1/26/2013

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Yearly change in CPI-U


  1. But what is the compounded rate of inflation ... that is, 3% this year added to the 4% last year, etc. ...

    That graph would have a big impact!

  2. I've updated the intro:
    Prices in 2010 were 27.4 times higher than in 1900 -- an average increase of 3.1% per year.
    I hope that helps.

  3. Anon,
    NOW I think I get it. Check back next week; I'll be posting a graph showing the change in purchasing power.


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