Whether it’s a service or a tangible item, when you pay more for it in the future than now, it’s called inflation.
CPI or Consumer Price Index is basically the prices consumers or households pay for goods and services. For a particular base period, compilation of the prices for a basket of goods is done. Data linked to the prices of the items in the basket are then collected every month. This data is then used to make comparison of the prices for a certain month with the prices from a different time period.
The role of variables-
Variables influence inflation in a major way. In the future, certain products will not just become better, they will also get cheaper. For instance, technology goods like television, mobile phones are definitely going to get better in the future, but people will probably be able to buy them at cheaper rates than now. This is one variable. Another variable could be the composition of the basket of goods and services. So, there will be some people who for whom the concerned basket of items would seem more relevant, and for some it would be of less relevance. For example, if we take into consideration the elderly people, then for them healthcare services would be more relevant than child education. So, a basket where health care features dominantly will be more relevant to the elderly citizens of the country than a basket that attaches more importance to child education. So, one thing that may be inferred here is that not all groups of people are affected equally by inflation numbers.
Although, inflation is monthly reported, it can be affected seasonally too. And that is why the year-over-year number is of more value. And because energy and food are volatile factors, they are generally kept out of the general CPI calculation. Housing often makes a huge part of the basket, and is split between rental and owner’s costs. So, basically one should accept CPI changes keeping in mind the fact that different families see different amounts of inflation. You should also keep in mind that the government has an upper hand in deciding on the manner in which the CPI gets reported.
Nevertheless, the CPI is a great indicator of how fast the purchasing power of money is decreasing. As this happens more money needs to be invested to avail the items present in the basket with each passing year. In today’ world inflation is considered normal. The last time there was no inflation was during the great depression some eighty years back.
How portfolios get impacted-
If suppose 3% is the current inflation rate and we have cash at hand with its sub 1% interest yield, then every year we are losing 3% of the purchasing power of the money we are holding. And that is why an investment portfolio should be created and maintained keeping in view the factor of inflation.
If you are investing for retirement, then make sure your stream of income in the form of pension has also been adjusted to the rate of inflation. Otherwise, your pension value will hold much less significance in the future than now. Remember, inflation causes a drain in wealth in the future. So, giving it due importance while carrying out financial planning is important. If you don’t understand much of this concept, then approaching your financial advisor for guidance would be the best bet.