December 5, 2015

Why Claims Of Inflation Being So Important In Financial Planning Are All Bogus?

Inflation is supposed to be the silent killer. It is supposed to be the invisible tax on your returns. However, this claim is more of a bogus than anything else.

First, inflation is measured for a basket of selected goods and services. Your actual consumption may be far away from the basket constituents.

Secondly, if you analyze your expenses, the expenses towards items such as home loan EMIs, rentals, education of your kids, food and grocery purchases, medical needs, consumer durable goods and utility bills taken together would account for a significant percentage of the total expenses.

If you look at the above list of items, few points would strike you immediately:
  • House costs went up till 2006 but then tanked and have stayed almost stagnant since then. Also, how many houses would someone in the middle class need to buy in his lifetime? This is an important consideration because if you are rich then inflation and recession would not mean much to you.
  • Cost of consumer durable goods and gadgets like TVs, smartphones, etc. have actually come down over the last few decades. 200 dollars can buy a much much better smartphone today as compared to ten years back. And as per time value of money 200 dollars today would be much lesser than 200 dollars ten years back.
  • Cost of automobiles has not gone up much since last more than ten years. Again the mileage and features you get in a car today easily offsets the additional cost you may have to incur.
  • More importantly. the cost of fuel has crashed from 100 dollars to 40-50 dollars today. So with a more fuel-efficient car combined with very low fuel cost the overall cost of driving has come down significantly.
  • Interest rates for taking loans have stayed at reasonably low levels. In fact the rates in the USA have been ridiculously low since last few years starting 2007 when the housing bubble burst open. So even if you have to buy consumer goods and gadgets today, loans at low rates are easily available.
  • Food and grocery prices have not actually gone up but have become highly volatile. They may be high during certain periods when there is a demand-supply mismatch. Again, in such cases if you are in middle class you would typically avoid buying such food items temporarily or at least cut down their consumption or use a substitute. 
  • Cost of food items would never rise too high and the reason is Governments the world over will not allow it to, for obvious political reasons. Imagine a loaf of bread which costs half a dollar In India becoming 100 dollars some day in the future. That would be simply impossible other than currency crashing so much that the Government will have to change the currency.
  • Cost for medicines have not gone up too much. Cost of medical treatment excluding medicines have certainly gone up in the last ten years. Again, it is likely to stagnate now given that public health is a touchy issue for the masses and Governments will never allow it to become so expensive that they get out of reach of the entire middle class and those below.
  • The above logic applies to cost of education also. Cost of education has certainly gone up but is likely to stagnate. Imagine someone earning 40k INR in India having to dish out 10k INR for the school fees and other expenses every month. This cannot continue long since every parent would want good education for their kids and not many people are getting 40k INR or more per month in India. This asymmetry in the society will gradually turn into a major political issue.
  • Utility costs also have not gone up that significantly. Water prices have not gone up too much and electricity charges have gone up gradually in the past but are stagnant now. Gas prices have stayed at the same level for many years (and in fact have come down recently due to the world oil and gas prices crashing). Broadband and telecom services have remained at the same prices for several years now. Again, these are public goods and services and Government will always exercise some degree of control on the prices.
Remember any excess in the society will have to be balanced out some day. Cost of living cannot go up so high that majority starts suffering. It is an ideal condition for revolutions to start. And then the Governments may have to intervene wherever there is an excess. The silent majority has not remained silent for very long in then history of human civilization.

Inflation is given more importance than it has in reality. Financial planning should assume reasonable returns with some impact of inflation. However, as explained above, in many cases the impact of inflation is simply not there (in case of electronic gadgets, the opposite has happened due to technological and productivity improvements) or it is minimal or is high today but is likely to stagnate and thereby get diluted in the future.

In light of the above, it is clear "Why Claims Of Inflation Being So Important In Financial Planning Are All Bogus?".

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