Economics 101 —Inflation and Interest Rates

Inflation has a big impact on an investor’s ability to plan and save for the future. As an example, since 1926, the annual rate of inflation in the United States averaged just over 3%.1 While that may not seem like much, even at 3% you will need about $222 in 2030 to replace what $100 buys today.

Erosion of Buying Power
The most common measure of inflation is the Consumer Price Index, or CPI, which is released monthly by the U.S. Bureau of Labor Statistics. The CPI compares current and past prices of a model “market basket” of goods that represent a variety of categories, including housing, food, transportation, and apparel. The Federal Reserve, our nation’s chief banker, keeps a vigil on changes in the prices of goods and services, using interest rates as a tool for managing inflation.

In essence, inflation erodes your purchasing power and works against the value of your investments. Conservative investments, like a bank account or a money market, may not offer the kind of growth potential typically needed for a retirement portfolio.2 To pursue your long-term financial goals, you may want to consider investments with enough return potential to outpace inflation. And that may mean stocks.3

Growth Potential of Stocks
Historically, stocks have provided higher returns than all other asset classes over long stretches of time. During the 30-year period ended Dec. 31, 2003, the average annual total return for a portfolio made up of stocks found in the S&P 500 index was 13.64% — more than double the rate of inflation. During the same period, the return on investments in long-term government bonds was 9.52% and money markets 6.33%.4

In exchange for higher return potential, stocks generally involve greater risk of short-term price fluctuations than other asset classes. And, of course, there is no guarantee that past performance will be repeated. A financial professional can help you create a diversified mix of investments that suits your financial goals, time frame, and tolerance for risk, and anticipate the effects of inflation.

1Source: Federal Reserve Bank. Inflation is represented by the annual change in the Consumer Price Index for the 30-year period ended December 31, 2003.
2Note: While a money market fund aims to maintain a stable $1 share price, there can be no guarantee that the fund will achieve this objective, and its yield will vary.
3Note: Consider consulting a financial advisor before deciding whether a particular investment is an appropriate choice in light of your specific financial needs and risk tolerance.
4Source: Standard & Poor’s. Stocks are represented by the S&P 500, an unmanaged index of 500 stocks generally considered representative of the U.S. stock market. Long-term government bonds are represented by the total annual returns of long-term Treasuries (10+ years). Money markets are represented by the yield of 90-day Treasury bills. Results include reinvested dividends. Individuals cannot invest directly in any index. Past performance cannot guarantee future results.

©2004 Standard & Poor’s Financial Communications. All rights reserved.