Inflation

Milton Friedman noted that “Inflation is the one form of taxation that can be imposed without legislation”, while polar opposite Vladimir Lenin observed that “The way to crush the bourgeoisie is to grind them between the millstones of taxation and inflation”.  Inflation is simply the result of increasing the supply of money, such that things cost more in the future than today.  While this seems entirely undesirable on its face, governments print money and willfully cause some inflation to stabilize declining economies, to reduce the cost of paying back previous debt, and for other such functions.  But, this comes at the expense of the average taxpayer, who loses some percentage of the value of their dollar-denominated assets every year to inflation.

Even a modest 3% inflation will eat away a quarter of a dollar’s buying power every ten years, or halve its buying power every 24 years.  Although the Federal Reserve has only two mandates, the first of which is to control inflation and the second to minimize unemployment, we’ve seen double digit inflation twice in my lifetime – from 1974-1975 and from 1980-1981.  The Fed’s stated target of 2-3% inflation target therefore cannot be considered a guarantee, or even a likelihood, given our tremendous debt and faltering economy.  The temptation to cut the cost of our debt in half by inflating the dollar 100% is strong, and politically more palatable to many politicians than raising income taxes, although the net result is similar.

Is the standard 3% assumption a reasonable one?  I sure hope so, but it may be too low.

We know that our estimated 7% yearly return in retirement minus 3% inflation gives us about 4% per year to withdraw as retirement income using the standard model, and have discussed whether 4% is reasonable for income, but what about our estimated 3% for inflation or 7% for returns?  This example shows that inflation is just as relevant to the effective value of retirement income in present-day dollars as rate of return or amount withdrawn per year.  If one guesses that inflation may average a percent or two above 3%, as I believe is possible, this must be reflected in either a rate of return higher than 7%, or a rate of withdrawal lower than 4%.  I’ve already determined that 4% withdrawal per year is unlikely to be a high estimate, which leaves me chasing returns higher than 7% per year.