The big news last month on July 31, 2019 was from the Federal Reserve (Fed) meeting. The Fed lowered the federal funds rate by 0.25% for the first time since the end of the 2008 financial crisis.
At these meetings, the Fed can make adjustments to the federal funds rate to influence the U.S. economy. When the economy is heating up, the Fed can increase the rate to try and keep the economy from overheating. A good example of this was between 1981 and 1982 when inflation was running 14%, the Fed increased the federal funds rate to 20%. When the economy is getting weaker, the Fed can lower the rate to try and entice people to borrow and spend money. A good example of this was between 2000 and 2003 when the Fed decreased the federal funds rate to 1.25%. In 2008 they decreased the federal funds rate all the way to 0%. After the recent cut in July, the current federal funds rate is now 2.25%.
The Fed cited lower inflation as the main reason for the cut this July. The current inflation rate is around 1.5% compared to 2.95% in July of 2018 (one year ago). Inflation is a key metric that the Fed uses to make rate decisions and it is important to understand. So, what is inflation, why is it a big deal, and how does it impact financial plans?
What is inflation?
Inflation is the general increase in prices that happens overtime as our economy grows. As prices of goods and services rise, our purchasing power (amount your money can buy) decreases over time. A common example is the price of gas. In 1959, a gallon of gas was around $0.27. Inflation has caused the price of gas to increase a lot over the years, today the national average for a gallon of gas is over $2.75.
Why is inflation a big deal to you?
Over time inflation can significantly reduce the purchasing power of money that you have worked hard to save. As an example, if you have $100,000 saved today at the age of 60 and you put it under a mattress earning 0% for 25 years. At age 85, based on 3% inflation you will only have around $48,000 of purchasing power left. Said another way, your $100,000 will only buy things that cost $48,000 today. The only way to stop that from happening is to invest your money and earn an investment return equal to or above the inflation rate.
How to plan for inflation in retirement?
As part of the cash flow planning we do for clients, we must make assumptions about future returns and inflation. We explain to clients that the most important number is actually the difference between the two numbers which is called your real return (real return = investment return minus inflation). For example, if your return is 6% and inflation is 2.5% then the real return 3.5%. If your retirement cash flow projections look good with a real return of 3.5% then you can feel confident that you will be successful in retirement if you earn a real return each year of 3.5% or higher. As an example, if inflation jumps to 10% and your investment return is 13.5% that same year, you real return is still 3.5% and your retirement cash flow will still work.
Understanding the assumptions used in your retirement plan will help you evaluate each year if you are staying on track or if you need to make any adjustments.
A good financial planner will go over all of these assumptions with you as part of your financial plan. They can also explain why they used the numbers and what the impact will be if the real return is different. With the Fed making changes, now is a great time to review your financial plan to make sure the assumptions used are still reasonable given the economy today.