Inflation
Inflation is the loss of purchasing power as a result of too many dollars chasing a limited supply of goods and services (I hope you enjoy the illustration :-) ).
The long-term average inflation rate in the US has been about 3% per year. For example, $100 in 1980 would buy the same amount of goods and services as $285 dollars would buy today. In other words, the current purchasing power of money today is worth more than the same amount in the future; therefore, prudent investors and economists adjust for inflation when evaluating data.
The Consumer Price Index (CPI) is used to measure inflation and its counterpart, deflation. Investors typically use the change in CPI as a Lagging Economic Indicator. Similarly, economists use inflation to adjust a Leading Indicator called Money Supply (M2), which measures the currency in circulation and cash on deposit at a specific time. Economists also use inflation to adjust Real GDP, which is GDP (Gross Domestic Product) less the CPI. Lastly, investors use inflation to evaluate Real Return, which is the Rate of Return less the CPI.
Inflation can eat away at investment returns, which is why measuring the “Real” Return is so important. The systemic investment risk that inflation imposes is called Purchasing Power Risk (aka Inflationary Risk or Inflation Risk), which is the risk that inflation will undermine an investment’s return. Fixed-income securities (e.g. bonds) carry the most amount of Purchasing Power Risk. For example, if a bond yields 5% per year and inflation is 2%, the Real Return is 3%, but if inflation jumps to 4%, the Real Return is just 1%.
