Inflation
and the Consumer Price Index
Inflation is
defined as a sustained rise in the general level of prices of consumer
goods and services and is measured by the non-seasonally adjusted
Consumer Price Index for All Urban Consumers1
(CPI). The CPI is a good measure of inflation as experienced by
consumers in their day-to-day living expenses and is often referred
to as the cost-of-living index.
In an inflationary
environment, today’s dollar may be worth only a fraction of
a dollar next year. Inflation poses a problem for all investors,
including holders of fixed-income investments, because the effects
of inflation can erode the real value and purchasing power of coupon
payments received in the future. To illustrate, it takes $14,058
in 2007 to buy what could be purchased for only $10,000 in 19942.
For investors who rely on the stability and predictability of fixed-income
investing, finding ways to limit or mitigate the effects of inflation
are crucial.
It’s clear
from the example above that investors who are saving for some future
expenditure, be it a major purchase or living expenses in retirement,
could benefit from an investment that preserved purchasing power,
but what about other investors? Individuals already in retirement
are keenly aware of the effect of inflation on the fixed payments
generated by many investments. An investment with coupon payments
linked to changes in the CPI can help investors maintain the same
standard of living even as prices rise. In fact, any investor with
a well thought out asset allocation strategy would be wise to consider
adding inflation-linked investments to their portfolio. Such investments
provide diversification benefits when combined with equity and fixed-income
investments and also help to offset the negative effect inflation
can have on other asset classes.
1 Additional information about the Consumer Price
Index can be found at www.bls.gov
2 Source: U.S. Department of Labor’s Bureau of Statistics
inflation calculator
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