February 2, 2017 | by James Behr Jr & Christopher Paleologus
Remember a time where McDonald’s dollar menu actually had items that were a dollar? McChickens, chicken nuggets, and cheeseburgers; each of these could be purchased with a single crisp dollar bill.
Those times are long gone. Their dollar menu has ceased to exist; it’s now called a value menu. The price of everything on that menu has risen from 20-100%. Four piece nuggets are $2, McChickens are $1.29. Every time you see a restaurant menu that has prices crossed out in sharpie or white-out, it’s safe to assume that their prices have risen.
The question is why?
It’s most likely because of inflation, not because they are trying to rip you off.
Inflation is the phenomenon of universally rising prices, with your money losing purchasing power. Every year, prices of both products and services rise across the board. This is the reason that ten years ago you could have bought 100 McChickens with $100, but today, you can only buy about 77 with the same amount. As you can see, if you measure your wealth in terms of the number of McChickens you can buy, you have lost money.
Inflation is measured monthly by using the Consumer Price Index (CPI), which is a collection of goods and services designed to be representative of the entire market. The Federal Reserve can control inflation through their control on the economy. One of their goals is to limit inflation in the long-term to 2% annually, because mainstream economists currently believe that low inflation is a sign of economic health. If it costs $100 to buy everything on the CPI in 2016, and $102 to buy everything on the CPI in 2017, the annual inflation rate was 2%. In other words, you can buy 2% less with $100, meaning that your money is worth about 2% less.
However, because the contents of the CPI are not public information, it begs the question whether this 2% value is too low, especially when some prices, like food and energy, have risen much faster. John Williams, an economic consultant, believes that the real inflation rate is closer to 5%. Either way, it means that consumers are losing purchasing power. What does this mean for you, as a financially responsibly individual?
Let’s use the official inflation rate. It means that prices across the board will rise about 2% per year. After five years, 2% compounded annually means that prices will have risen 10.4%. After thirty-five years, 2% compounded annually means that prices will have risen by 100%. The $1 McChicken now costs $2.
If you left your money under your mattress, you would have kept the dollar amount, but your purchasing power was halved. You are poorer relative to what you are able to buy with that amount of money.
Inflation is a headwind that erodes and whittles down the value of your cash over time. This is why keeping money under your mattress is a bad idea. You will lose money continuously to the compounded effects of interest. The only way to avoid losing money to inflation, is to compound your money at the same rate. If inflation is 2%, you need to make at least 2.01% return on your money just to retain purchasing power. If inflation is 20%, you need to make 20.1%.
Whether the inflation rate is 2% or higher, the conclusion is the same; cash loses value over time. Your goal should still be the same: to earn as high of a return on investment as possible annually given your particular risk tolerance.