A couple of weeks ago I wrote what turned out to be a very popular and very controversial post about how the 4% retirement rule applies to dividend investing. I received a lot of interesting feedback that I will certainly be looking into in the next few weeks. Today, I wanted to discuss one part that I was highly criticized on; my inflation assumptions. As a reminder, I wrote the post assuming a 2% long term inflation rate.
Is 2% Too Low?
Many said that it was way too optimistic to assume a 2% inflation. That in fact, inflation was likely to jump to 3-4% or perhaps much higher. Quite a few said that within a few years, inflation would likely reach 10% or more. That certainly gives me a lot to answer. I will answer a few different points here.
Yes, My 2% Was Just An Assumption
When I wrote the post, I wrote down a 2% inflation rate because that seemed about right. Probably a bit of mistake as these days we are seeing historically low inflation rates and it might be optimistic to think it will remain so low. That being said, I don’t feel like I am way off either. I understand that many expect inflation to jump. That inflation could reach 5%, 10% or even higher. But how could anyone really make long term assumptions using such numbers? I mean honestly, is there any chance that long term inflation will be 7 or 8%? Yes, absolutely. But is that a likely scenario? Not in a million years.
I still believe that financial planning is all about trying to get an accurate picture of where we are, where we are trying to get and then determine the most likely “optimal” route to get there. How could somone realistically expect that high of an inflation rate? So no, I would not take seriously anyone that would be using a 10% long term inflation rate.
In the same way, do I really expect markets to increase by 6 or 7% every year, inflation to be 2 or 3%? No. Markets might crash next year and inflation could skyrocket. But trying to predict the timing of such events for long term financial planning is not really possible. We are stuck with trying to find assumptions that can hold over the long term.
A More Logical Approach To Inflation Predicting
I can think of 3 ways to predict long term inflation rates.
The Fed is likely the most sophisticated economic forecasting firm in the world and while it is wrong like everyone else, It still remains very reliable. The Fed expect these inflation rates in the next 3 years:
There are 2 obvious weaknesses here:
#1-Many people do not trust the Fed’s forecasts
#2-It’s not very long term as you can see
The University of Michigan is very well known for the surveys that it does among the US population regarding how they perceive the economy, what they expect, etc. They do also have such a survey for 5-10 year inflation. That rate currently stands at 3%…. A bit higher than what I was using no doubt.
#3The Better Approach To Inflation Forecasting
You might be familiar with TIPS bonds, Treasury Inflation Protected Securities. These are bonds that will return the “given” inflation rate + a premium for inflation. For example, if you bought a 1 year US government TIPS, it would return the same as a “regular” 1 year bond but would also account for inflation. As investopedia explains it:
“A treasury security that is indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed. Interest on TIPS is paid semiannually. TIPS can be purchased directly from the government through the TreasuryDirect system in $100 increments with a minimum investment of $100 and are available with 5-, 10-, and 20-year maturities.”
So what would the difference be between a 5 year US government standard bond and a 5 year TIPS? It would be the expected inflation. Here are the current numbers for different maturities:
-5 year expected inflation rate: 1.94%
-10 year expected inflation rate: 2.24%
-20 year expected inflation rate: 2.35%
-30 year expected inflation rate: 2.37%
For example, this means that an investor that will receive the inflation over 30 years is willing to pay 2.37% more than an investor that isn’t on US government securities.
Clearly, my 2% is a bit low, but not by much….
Is This Method Perfect?
Obviously, it is not. But I would argue that using such a method is the best available method. Why? Because if someone had enough certainty that inflation was going to jump. That person would start buying 30 year TIPS. He could then sell 30 year “standard” bonds. That would gradually increase the yield difference, especially if enough investors had that same belief. I’m sure that many expect 30 year inflation rates to be over 2.50% and maybe over 3%… But there are as many investors who think inflation will actually be lower, maybe under 2%…
So yes, I should have used a higher inflation assumption…
I should have used 2.37% instead of 2%. I will adjust accordingly in my follow-up post:)