How to Prepare for Inflation

Anyone inclined to look for silver linings can find one in the Labor Department’s latest inflation figures, which show that prices have gone up just 1.8% in the 12 months through the end of November.

That’s well below the long-term average of about 3%. And it helps take the sting out of low yields on bank savings, money markets and other fixed-income holdings. If you have a two-year certificate of deposit paying 1.374%, the average according to the BankingMyWay.com survey, you’re losing a just a little to inflation while keeping your money safe and accessible.

But how should today’s low inflation rate influence a long-term investing and saving plan?

The financial markets expect inflation rates to stay low for years. That can be seen in the “breakeven rate” figured by subtracting yields on five-year Treasury notes from those on five-year Treasury Inflation-Protected Securities. The difference is about 1.6 percentage points, reflecting investors’ belief that inflation will average around 1.6% for the next five years. Investors expect inflation to average 2.25% over the next 10 years.

That, however, is no reason to let down your guard. Inflation is similar to investment returns, with the long-term average masking a lot of fluctuation. If you assume your investment return will average 7% a year, you should not go out and spend the excess if you earn 10% or 15% in a given year, since that excess gain is needed to offset the years your investments lose money.

In the same way, you have to keep preparing for significant levels of inflation even if the rate is low for the time being.

Also, the overall inflation rate is based on prices of thousands of goods and services that probably do not reflect your own spending. If you face college tuition or have a lot of out-of-pocket expenses for health care, your personal inflation rate may be a good deal higher than the average.