INFLATION, INSURANCE, AND THE ILLUSION OF NOMINAL DOLLARS
Guest Post By, Frank A. Jurs II
Most people, professional and laypeople, believe that the term “inflation” means the rising cost associated with goods and services. While the rising cost of goods and services are a byproduct of inflation, it’s not inflation in and of itself.
Inflation is an expansion (think of a balloon inflating) of the supply of money – physical cash, bank reserves, digital dollars accounts, checking/savings accounts, loans, available credit etc.
As more dollars are created, loaned, borrowed and spent – the cost of goods and services generally increase to account for the increases in the quantity of dollars chasing the limited amount of goods and services. The more dollars that are created dilute the purchasing power of each dollar that existed before. As dollars become less valuable it naturally takes more of them to buy the same things, all other things being equal.
If you think about it, this makes sense. One million dollars in 1980 and one million dollars in 2018, are the exact same amount in nominal terms, but in terms of the power to exchange them for goods a services – they are far different.
This is the illusion of nominal dollars. They function as a unit of account, but not as a store of value.
Do you ever wonder how the median sales price of a new home (data for 2016) is well over $300,000, when the median priced home didn’t even cost $8,000 in the 1950s? College? Healthcare? Groceries? Energy? Expansion of the supply of money and a limited amount of goods lead to an increase in prices. In broad strokes, it’s really that’s simple.
Higher prices for goods and services in the present day is not the only way inflation impacts your financial life.
Money, when you get right down to it, is really just a promise. It’s a promise that if you sacrifice pleasure, consumption and spending in the present day, your savings stored into the future will provide a better quality of life for you later on.
Sadly, the effects of monetary inflation steal that promise from the future, and makes planning for it much more difficult and tiresome. A penny saved is no longer a penny earned.
Let’s take the advance planning around life insurance for instance. Firstly, I am not a licensed salesman or an expert in insurance, insurance policies and I am not offering any advice to you with respect to their benefits, utility, necessity, or viability. Do your own due diligence and consult a insurance expert.
That being said, let’s say that hypothetically you are interested in a life insurance policy that may pay out some time long into the future – twenty or thirty years down the road. How can you forecast today what that money will be worth in the future?
The value, or purchasing power of money is not static, and hasn’t been for many decades. What $1,000,000 buys today, it likely will not buy in a year, ten years or twenty years. So there is an obvious predicament with respect to responsibly planing for your financial future.
The Federal Reserve (US Central Bank) has publicly announced that they have a 2% yearly “inflation rate target” since 2012. Without much thought, 2% seems insignificant – but what does that really mean for your planning?
If prices increase 2% per year, the US dollar will lose approximately half of its purchasing power in around 35-36 years, and nearly three quarters of its value in the average person’s lifetime. This makes planning for the future complex and uncertain.
Of course inflation rates fluctuate depending on what goods and services are being analyzed (see CPI), but let’s go with 2%, and give the Federal Reserve the benefit of the doubt that they will meet and not exceed their target.
This means that if you are thirty-five years old today, and this inflation goal is reached consistently ever year, every dollar you have saved will be worth fifty cents by the time you reach seventy years old.
So let’s say you were to secure a 30 year $1,000,000 life insurance policy at 35 years old (2018). With 2% price increases (inflation) per year, that policy, although still worth $1,000,000 in nominal terms, would only provide just over $500,000 worth of present day purchasing power if it paid out 30 years later in 2048. This is the illusion of nominal dollars. What happens if the inflation rate reached 7% per year? In that scenario, the $1,000,000 policy would only be worth approximately $500,000 (in present day purchasing power) ten years later in 2028.
It’s not the amount of dollars, it what they can buy you.
This math is not only helpful with future planning, but is helpful to understand present day incomes. Hypothetically, let’s say the US experiences a 3% money supply inflation and prices for everything we consume rise by approximately 3% each year. Let’s also say for each of these years your employer rewards you with a 1% salary increase. At the end of a five year period you have been given five consecutive wage increases of 1%, and prices have risen by 3% each of those same years.
Did you really get a salary increase?
Well, in nominal terms, you did, because you are earning a higher quantity of dollars and your salary is larger. The problem is that because prices are increasing at triple the rate of your salary, you end up with less purchasing power, or ability to exchange your dollars for goods. Even though you have “more” money, you are actually far less wealthy.
Your quality of life can decline even as your salary increases.
Incomes not keeping up pace with price increases (inflation) have resulted in most households requiring two (or more) full time incomes to get by on what one income covered only a few generations ago.
The key to understanding money, and the ability to plan for an uncertain future is to realize that it is not necessarily the quantity dollars that you earn, it’s what those dollars get you in the marketplace now, and in many years from now.
In nominal terms, a person earning $50,000 per year in 2018 is doing far better than someone who earned $6,000 per year in 1950, but what about their purchasing power? Not so much.
A $6,000 yearly salary is equivalent to over $64,000 a year in 2018. So, when planning for the future, via investments, savings or insurance, keep in mind that our currency can be created in virtually unlimited quantities by which price increases (inflation) are most always the result. These price increases over a lifetime, diminishes your purchasing power, and the very promise that money is based on. Due to these facts, it is important you understand that planning today, for tomorrow, is a complex and sensitive responsibility.
The author is a part time author and private investor from New York.
(Nothing whatsoever in the above article should be construed, interpreted, or used as investment advice. The above content is the opinion of the author and is not meant in any way to advise anyone on investment decisions, or be interpreted as advice on any strategy, investment product or plan).