Consumer Price Index and Inflation
The Consumer Price Index (CPI) and inflation are directly related. Although, the formula for calculating the inflation rate is relatively simple the truth is nobody gives a good gosh darn.
And maybe we shouldn’t given it is a government calculated number and the government actually tells us what it is for the year every year. In fact, watch any business show on television and you will hear the talking heads spew forth about inflation and the CPI.
It is helpful to know the agency responsible for computing the CPI and informing the general population of that number is the Bureau of Labor Statistics or BLS for short. They actually survey thousands of prices all over the country and formulaically compute the Consumer Price Index and the inflation rate.
For any index to be worth its salt it has to have a base rate to be used for comparison purposes. This means somebody or some agency sets that base. With the CPI it is the BLS and currently the base year for comparison purposes is 1984.
The truth is it wasn’t exactly 1984. What the government math wizards did was use the numbers from 1982 -1984 took an average and called 1984 the year the CPI was 100. Just like magic they had a year and a number.
What Does This Mean to Me?
What does all this have to do with me you might be asking. Well, maybe a lot and maybe nothing. I will say if you are a senior about to retire or are already retired this number is important.
You see, inflation eats away at your buying power. If something cost one dollar in the base year, 1984, but costs 1.98 today, inflation has eaten ninety eight cents more out of your nest egg.
It could get more complicated but why complicate a simple formula I’ll show you in a minute so you can break even with inflation. As seniors we face medical bills, taxes, hospital bills. All the same bills pre-senes and younger people face too.
But what we don’t face is longevity to combat this bully called inflation. It simply eats away our money and we seemingly can’t shoo away the monster.
Year after year it nips at our heels.
Breaking Even With Inflation
Fortunately there is an easy to use formula to help us calculate the investment rate of return we need to “break even” with inflation. Expressed as a fraction it looks like:
Inflation Rate / 1 – Tax Rate
Obviously we need to know the inflation rate and our tax rate. I will assume the inflation rate is 5% and the tax rate (bracket) is 30%. Our equation looks like:
.05 / 1 – .3
.05 / .70
Dividing we get this number: 7.14
7.14 expressed as a percent is 7.14 percent or .0714. This is the return we would need to receive to stay even with a 5% inflation rate in a 30% tax bracket.
We could have more fun with the Consumer Price Index and inflation but this appears to be enough fun for this article. Keep this formula in mind as you plan your retirement.
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