The Magical Compounding of Interest……and Inflation?

A quick online search reveals that overall prices in the United States rose 5% compared to May of 2020. Have you heard anyone complaining about goods and services getting more expensive lately? Prices have been on the rise thanks to inflationary pressures. 

Merriam-Webster defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services”. In simpler terms it means that money has less value over time. 

Remember compound interest? We usually think of this formula for investments, but this fits inflation as well. 

Morningstar predicts annual inflation will be 2.5% in 2021 (the average price increase compared to the period a year prior).  

So, what does that mean to the value of $500?  

P = $500 

I = .025 

N = 1 

500(1+.025)1 = 512.50 

If you had $500 in December 2020 you would need $512.50 so have the same purchasing power in December of 2021. What if we add in Morningstar’s prediction of 2.3% core inflation through 2022-2025? That comes out to be $561.30. This means in at the end December 2024 you will need $561.30 to get the same purchasing power as $500 did in early December 2020.  

What if you had $500 in a savings account in that same period? Interest on savings accounts currently is very small compared to the inflation rate. Chase is offering .01% on their savings accounts as of June 2021. Plug that into the formula and you get $500.25. Effectively you lost $61.05 because it takes $561.30 to get the same purchasing power in December 2024 as it did in December 2020. This is an unfortunate pitfall of very low-interest rates.  

So how do you combat inflation? Unfortunately, inflation is out of your control.  Inflation involves many different factors but investing wisely can help combat these effects. Luckily, there are multiple types of investments that have historically had returns that beat inflation.  A good financial advisor can help you identify these types of investments and help you understand the risks of investing in them. 

Contributed By: John Richter, CPA | DWD CPAs & Advisors