You Need to Forecast Inflation Just Like the Fed

NEW YORK ( BankingMyWay) -- What will the inflation rate be over, say, the next 10 years?

It's a critical question that guides decisions about things like buying homes, how much to save for retirement, or whether to take stock market risks or settle for the lower but safer returns offered by bonds and bank savings.

The short answer is that no one can predict the inflation rate for sure, any more than people can forecast investment returns or who will win the next 10 World Series.

But there is a figure that's widely accepted and it is (drum roll, please) 2.3%. That's the figure found in yields of 10-year Treasury inflation-protected securities, or TIPS, a government bond whose yield fluctuates with investors' best guesses about future inflation rates. While the 2.3% inflation rate is not guaranteed, TIPS do represent the combined wisdom of legions of investors, so they probably offer a better gauge than the predictions of a few economists.

So, assuming, 2.3% is the best number to use, how can you use it?

Housing

First, it should play into any decision to buy a home. Over the long term, home prices rise at about the inflation rate. While many homeowners expect more than that, prices cannot rise faster than inflation for too long without homes becoming unaffordable. When prices get too high, demand slackens and prices drop.

If a home's value will grow about 2.3% a year, it would take roughly four years to rise 10%, enough to cover buying and selling costs like the 6% realtor's commission, transfer taxes and various fees. In other words, you'd have to own the home for four years to be able break even --to sell without losing money. Because the housing market is still shaky, it would be wise to add two or three years to the breakeven period and not buy unless you plan to stay put for six or seven years.

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Long-term investors should use the inflation rate in several ways.

Savings

Your savings rate -- the amount of money you put into savings and investments -- should be increased each year by the inflation rate. For every $100 you save this year, you ought to save $102.30 next year. The following year you would save $104.65, figured by multiplying 102.30 by 1.023.

As you can see, inflation compounds, like savings, with each year's addition going on top of an ever-growing base. At a 2.3% rate, something that costs $100 today will cost $125.53 in 10 years, not $123.

That's why inflation is so dangerous to retirees who want to keep savings in "safe" accounts like banks or short-term bonds. With the one-year certificate of deposit yielding a scant 0.26%, a CD investment would lose buying power every year.

The stock market

To keep ahead of inflation, financial advisers recommend that even retirees keep a healthy portion of their holdings in stocks. Historically, stocks returns have beaten inflation by wide margins, though the ride can be bumpy. That's because corporations that issue stock can raise prices to offset rising costs of labor and materials. Stocks also benefit from companies' productivity gains, and stock returns have to beat inflation to compensate investors for the risk of loss.

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At 2.3%, inflation may seem low, especially for anyone who remembers the terrifying double-digit rates of the 1980s. In fact, 2.3% is just a tad below the long-term average of about 3%, and over long periods of time even these modest rates can do lots of damage.

--By Jeff Brown

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