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Investing Specialists

How Worried Should You Be About Inflation?

Your personal spending and inflation rate likely vary from the Consumer Price Index.

The 8.6% jump in the Consumer Price Index between May 2021 and May 2022 was stunning, and it marked the biggest inflation increase since 1981. A fresh CPI reading—for the 12 months ended June 30—is due later this week.

What you may not have stopped to think about, however, is that CPI is just a rough proxy for consumer spending. The housing category, which encompasses rents (or what an equivalent rental would cost a homeowner), utilities, household furnishings, and services like landscaping, is the biggest share of the consumption basket used to calculate CPI. It represents a 42% weighting in the CPI for All Urban Consumers (CPI-U), commonly shorthanded as CPI. And indeed, housing-related outlays are the biggest share of most household budgets. Food and transportation are the next-largest categories in CPI, representing about 14% and 18%, respectively. Recreation and apparel get smaller weightings in the calculation. Each of those categories has its own inflation rate. 

But what your household spends money on almost certainly differs from the typical U.S. household's. Take, for example, a new homeowner who has a sizable mortgage and is also making substantial home improvements while simultaneously purchasing furnishings, window treatments, and garden implements. Housing-related outlays are apt to be a bigger share of the new homeowner's budget than is likely to be the case for the population at large. Meanwhile, a retired older adult who no longer has a mortgage will likely have smaller housing-related outlays, as a percentage of household spending, than the general population, but healthcare expenditures may well be a bigger share of the budget.

In short, each of us has our own CPI, determined by what we spend our money on as well as what inflation has looked like in each of those subcategories.

Calculating Your Own

Given those variations, it can be helpful to use the CPI's weightings as a starting point for understanding inflation's impact on your household and figuring out what to do about it. You can get closer to a personal inflation rate by looking at your actual spending in each of the major categories and blending that with the inflation we're seeing in those areas.

On this spreadsheet, you can input your spending in each of the major categories, then calculate a personalized inflation rate that incorporates inflation by spending category. We've populated it with some sample data based on the CPI weightings and actual inflation rates in each category (through May 2022), but you can look back on your actual spending over the past year. You can also tweak the inflation expectations for each line item to align with your own experiences.

One factor that will probably jump out as you calculate a customized inflation rate is the importance of transportation costs in driving recent increases in inflation. Transport-related costs jumped 19% in the one-year period ended May 2022, making it the category with the largest price gains by far. If you've had to purchase a car over the past year or even if you just frequently fill up the gas tank, you've probably seen a substantial increase in your outlays to get around. City dwellers who bike or walk, on the other hand, have been much less affected by rising transport prices. Ditto for the legions of workers who have curtailed their in-office time, and in turn their commutes, since the onset of the pandemic.

Food costs have seen the second-highest rate of inflation over the past year, and they're less likely to be variable among different consumers. (Everyone has to eat!) Even so, there are some interesting variations in the rates of inflation among subcategories, and they might affect whether your personal rate of food inflation is higher or lower than the baseline food inflation rate of 9.7% reflected in CPI. For example, the cost of food prepared at home has increased at a nearly 12% rate over the past year, whereas the cost of food consumed away from home (for example, in restaurants) has jumped by just 7%. Meat, poultry, fish, and egg prices have increased by 14%--a major driver of the rate of food-price inflation--whereas fruit and vegetable prices have escalated by a less painful 8%. Alcoholic beverage prices have seen a relatively mild inflation rate of 4%, but coffee drinkers have contended with a more painful 15% inflation rate over the past year.

Meanwhile, older adults' budgets have long been bedeviled by runaway prices in medical care and drugs. Price increases in those areas have recently been running below the broad CPI measure, however; the most recent medical-cost inflation rate was 3.7%. It's worth noting, though, that those costs have been trending up so far this year.

What Comes Next

As interesting as it can be to come up with a personalized inflation estimate, it's important to not come away with a false sense of precision about inflation. For one thing, inflation statistics are ephemeral: The one-year figures provided in the spreadsheet capture price changes in various categories amid a still-strong economy and supply chain disruptions. Additionally, your own spending patterns are bound to be pretty volatile based on what you have going on in your household. Over time, CPI is apt to be a pretty decent reflection of changes in your spending. 

Moreover, the number that really bears paying attention to is the trend in your actual, all-in spending, which depends on a few key variables: your fixed and discretionary expenses as well as what's going on with inflation in each of the spending categories. Ultimately, your actual household spending trend matters more than examining inflation on a small scale because you exert a level of control over some of your spending, whereas inflation is out of your hands.

If you'd like to figure out how insulated your financial plan is against inflation, the next step is to take a look at your income sources. Have changes in income made you "whole" with respect to inflation, or have your income sources fallen short? If you're still working and have received a cost-of-living adjustment from your employer over the past year, has that increase kept pace with increases in your personal outlays? If not, it's reasonable to ask for a raise or scout around for a higher-paying job, especially given the strength of the job market today. If you’re retired and receiving income from Social Security, you saw a nearly 6% increase in your income for 2022. However, that amount may or may not reflect your personal inflation rate. Moreover, Social Security may not cover your total household spending; you may be pulling from your portfolio to cover additional outlays.

Thus, after examining income sources, the next step is to take a look at how protected your portfolio is against inflation. Given the fluctuations in the value of long-term investments, it's unrealistic to expect your portfolio's return to match inflation on a 1:1 basis annually. Treasury Inflation-Protected Securities and I Bonds receive an adjustment to match actual changes in CPI, but most investors will want to diversify beyond them in an effort to capture a higher long-term return than these bonds can offer. Stocks are by no means a direct inflation hedge; after all, inflation is up by nearly 9% over the past year, but a basket of global stocks has lost about 16%. Over time, however, stocks have outearned the inflation rate by a comfortable margin, which is one reason that even retirees should hold a healthy share of their portfolios in stocks.

On the flip side, securities with fixed payouts—nominal bonds and cash—are more vulnerable in inflationary environments. Retired investors and people approaching retirement will want to hold them to provide a stable reservoir for their cash flow needs and to balance out the volatility in their long-term portfolios. But given still-low yields on such securities, today's high rates of inflation make a strong case for not overallocating to them. 

Above all, be sure to avoid fighting the last war. Too often, investors have gravitated to investments with inflation-fighting characteristics, like commodities, only after inflation has flared up and such investments have enjoyed a strong run. If you plan to hold such investments as a means of defending against inflation, it's wise to use them strategically rather than as tactical hedges.