Inflation impact on time value of money

Inflation impact on time value of money

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It can be tricky to grasp the real impact of inflation on our money. Inflation, effectively shrinks the value of money over time, making it particularly important to find avenues to potentially boost returns on long-term savings and investments.

What is inflation? 

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy. As an economy grows, businesses and consumers spend more money on goods and services. In the U.S., inflation is often described as “too many dollars chasing too few goods”. As spending outpaces production of goods and services, the supply of dollars in an economy, exceeds the amount needed for financial transactions. Result is, a decline in purchasing power of the dollar.
 
What has been the historical inflation rate in USA?
Table I
Historically, the annual rate of inflation in the U.S. has hovered around 2%. Average being 2.2% for the period 2000-2018, which includes the great recession of 2009.

 How does inflation affect savings and investment returns?

 If inflation is higher than the interest or dividend paid on savings or investments, it essentially means that the value of money is falling over time. Since inflation chips away investment returns, a good investment must outpace inflation, to increase real purchasing power. Fixed-income investments, such as Bonds and CDs aim to produce a stable income in the form of interest. Due to the fixed nature of these investments, if inflation rises, their purchasing power declines. Suppose an investor bought a five-year fixed-income security with a principal value of $100,000. Based on an annual inflation rate of 2%, the value of principal, adjusted for inflation will sink to about $90,000 over the five-year term of the security.
 Due to the impact of inflation, interest rate on fixed income securities could be expressed in two ways:

Nominal or Stated, interest rate is the rate of interest on a fixed-income security without any adjustment for inflation. The nominal interest rate reflects the rate of interest, if inflation were zero.
Real interest rate on a fixed-income security is the nominal rate minus the rate of inflation. Because it takes inflation into account, the real interest rate is more indicative of true growth in an investment’s purchasing power. If a bond has a nominal interest rate of 5% and inflation is 2%, the real interest rate is 3%.Below Table II highlights nominal and real returns earned by each investment type, on $100,000 invested in each of them, for a period from 2000 to 2018. The inflation adjusted returns on CD and Bonds are calculated from the above Table I, whereas returns on Stocks and Multifamily investments for a similar period, were discussed in our previous article.  
Table II
Inflation affects all aspects of the economy, from consumer spending, business investment, employment rates, government programs, tax policies, and interest rates. Understanding inflation is crucial to investing, as it can reduce the value of investment returns, and in some cases the investment itself. One must always consult their tax or investment professional before making any investment decisions.
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