Projecting Inflation

Okay. So you’re planning your financial future and you know you’ve got to anticipate inflation. You know this because you’re observant and wise. Also because you read yesterday’s post. How much inflation will we see? Fagettaboutit. Nobody knows. You can’t predict it, you can only project it.

But that’s okay. You don’t have to be right in your projection; just be reasonable. Being the wise person that you are, your process includes a mechanism for annually updating your planning and projections based on reality—what really happened, not what you projected would happen. So next year, you’ll adjust for your inevitable failure to accurately predict the future, and effectively spread your error over the rest of your life. No, wait. Not “error;” that’s pejorative. Let’s call it “deviation.” No, that’s pejorative in a different way. Call it “dispersion.”

So what’s a reasonable assumption when it comes to future inflation? Here are a few options, any one of which is reasonable. Of these I prefer the first, since it presents a long-term average, and you’re planning for the long term.
• You can use inflation’s historical average. Between 1926 and 2008, inflation as measured by annual changes in the Consumer Price Index has averaged 3.01%.
• You can use the most recent rate of inflation. Between December 31, 2007 and December 31, 2008, the CPI has increased 0.09% (very tiny).
• You can glean the collective inflation predictions of many investors from the price of certain government bonds (called “Treasury Inflation-Protected Securities," or TIPS), which are designed to protect their owners from inflation. The rate of interest TIPS pay is generally lower than the interest rate payable on other government bonds with a similar maturity, and the difference represents, in a way, the bond purchaser’s prediction of inflation (as measured by the CPI) during that bond’s term. In fact, since interest rates on TIPS and other government bonds are set by an auction process, the difference in interest rate yields represents the collective inflation predictions of all government bond investors. As I write this, the most recently published spread between the yields on 20-year government bonds and TIPs is only 0.86%—not much. You can find the most recent interest rate yields for U.S. government bonds here (http://www.treasury.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml)
• Some financial institutions publish their predictions on their websites.

I don’t cotton to no predictions myself, and prefer instead to use a 3% inflation based on historical averages. It’s reasonable, and that’s all that counts. I’d be interested to hear your preferred approach to projecting inflation.

In any case, once you’ve settled on an inflation assumption to use in your projections, what do you do with it? That’s a subject for another post.