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Should investors worry about inflation?

February 17th, 2016 by

In a word, yes


One of the factors to take into account when deciding on a target rate of return for your investments is the rate of inflation. But according to Statistics Canada, inflation was actually down -0.5% in December. With inflation rates low or declining everywhere, do you really have to be concerned about the impact of the consumer price index on your investments? The answer may surprise you.

Inflation is deceptively low

“Inflation” is simply the term used to describe the rate of increase in the price of goods over time. If the price of goods that you purchase every day rises and your earnings or investment returns do not keep pace, then your “purchasing power” has decreased.

Yes, it’s true that annual inflation rates are currently low everywhere in the developed world. In some places, such as Japan or, from time to time, in the eurozone, inflation is even negative (that is, a general decline in price levels), which can become a “deflation” if it persists over time.

In Canada, the most recent monthly figures show a month-over-month decline in both the all-items and the core (with energy and food components removed) consumer price indices for both December and November. The annual rate for all-items CPI, however, edged up to 1.6 percent from 1.4 percent in November, while the Bank of Canada’s preferred measure, the core rate, slipped slightly, to 1.9 percent from 2.0 percent (the Bank of Canada’s target rate).

In the media release accompanying the Bank of Canada’s January 20 rate announcement, it said, “Inflation in Canada is evolving broadly as expected. Total CPI inflation remains near the bottom of the Bank’s target range as the disinflationary effects of economic slack and low consumer energy prices are only partially offset by the inflationary impact of the lower Canadian dollar on the prices of imported goods. As all of these factors dissipate, the Bank expects inflation will rise to about 2 per cent by early 2017. Measures of core inflation should remain close to 2 per cent.”

How inflation erodes your wealth

So inflation seems well contained. Is it still a threat to your longer-term investment returns? In a word, yes.

Here’s a simple example: According to the Bank of Canada website, $10,000 in 2005 would have a purchasing power of $8,244 in 2015, with an average annual inflation rate of 1.6 percent (just about where it is now). That “low” rate of inflation would have cost you $1,756 in investment value if you had failed to account for it in your investment planning.

When it comes to investments, it’s still important to factor in inflation, especially if you’re an ultra-conservative investor seeking safety. Consider, for example, that a one-year Treasury bill was yielding about 0.51 percent at the end of December. With inflation running at an annual 1.6 percent rate, your real return (after inflation and taxes) on the supposedly “safe” T-bill after one year would be negative – you will have made no money, and you will also have lost purchasing power.

Over 25 or 30 years of investing and saving, the erosion of purchasing power through inflation can add up to tens of thousands of dollars in lost returns.

Target inflation-plus returns

So when you update your financial plan this year, be sure to readjust the inflation rate you use, so that you’re consistent with the Bank of Canada’s target rate. And you should always set your desired investment return to be greater than the rate of inflation plus a cushion percentage to allow for future changes – inflation may be low now, but it won’t always be. Your financial advisor can help you set a longer-term target return rate, taking into account inflation and taxes, that’s suitable for your risk level and financial objectives.

Jul 28 2017 2:01am

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