Inflation Adjustments: Zero

October 15, 2010

It’s official: for the second year in history — and also for the second year in a row — there will be no inflation adjustment for social security benefits. The consumer price index now stands almost exactly where it did two years ago (actually a tiny fraction of a percent lower) so benefits will remain unchanged. We’ll get an official announcement of tax-related inflation adjustments soon, and those will come in close to zero as well. You can expect items like the IRA contribution limit and the annual gift tax exclusion to be the same in 2011 as in 2010.

This isn’t exactly bad news, but doesn’t feel right, and many of us need to adjust our thinking about personal finances, including investments and borrowing.

We’re so used to having at least a little inflation each year that we build it into our assumptions. A few years ago we might have been satisfied to earn 3% interest on our savings, with inflation running at 2%. Today we get the same result with 1% interest and zero inflation, but it feels like we’re doing poorly when receiving such a puny rate of interest.

If we need to adjust our thinking as investors, we also need to do so as borrowers. A drop of two percentage points in the rate of inflation has the same effect on our finances as an increase of two percentage points in the rate of interest we pay on mortgages, car loans and credit cards. That’s a sobering thought, one that should focus our attention on reducing those debts and make us think twice before incurring new ones.