The “Rule of 72” can help consumers roughly estimate how quickly inflation could cut the value of their savings.
Consumer Price Index Jumped +8.6% y/y in May
In a recent report, the US Department of Labor indicated that the Consumer Price Index (CPI) jumped +8.6% y/y during May. This is the fastest rate of inflation on gasoline, food and shelter costs since December 1981. (Please read our companion article posted on this week’s calendar on rising inflation costs titled “Inflation Keeps Rising as Do Gas Prices.)”
Obviously, this +8.6% y/y jump in consumer prices is affecting everyone’s buying power as well as their savings. Check out the so-called “Rule of 72” to help you measure the long-term effects of fast-rising inflation.
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Rule of 72
The Rule of 72 is a relatively simple way to estimate how many years it will take for investors to double their investment returns during “good” times and how long it will take for investors to halve their investment returns during “bad” times.
The workings of Rule of 72 during good times look like this: double 72 by the annual interest rate to calculate how much time it takes for an investment to double.
For example, money in a mutual fund yielding 2%/year would double in 36 years. Or, money in a mutual fund yielding 6% would double in 12 years.
With inflation or what we call bad times, the Rule of 72 works just the opposite: divide 72 by the annual inflation rate…72 divided by 8.6 = 8.37. Consumers would halve the value of their investment in about 8 – 8.5 years.
According to Charlie Fitzgerald III, a certified financial planner and founding member of Moisand Fitzgerald Tamayo in Orlando FL, “(The Rule of 72) works the same whether you’re implying an inflation factor – which is essentially deflating the purchase power of your money – or whether you’re applying the Rule of 72 to growing your money.”
Cautions to Consider Regarding Rule of 72
The Rule of 72 assumes that the current higher-than-normal inflation rate will last for a long time…more than eight years. Greg McBride, chief financial analyst at Bankrate, believes that the current rate of inflation will NOT persist for a long time.
Why? Several reasons including…
- The Federal Reserve began raising benchmark interest rates in March to curb inflation by increasing borrowing costs and slowing demand. The Fed has also announced and likely will continue acting against inflation by raising rates now and throughout the year until consumer spending and the overall economy cool.
- Not all households are equally affected by rising costs. For example, rising food costs are much more deeply felt by low-income earners than top-income workers. Top-income workers are less affected by higher interest rates on housing loans than by volatility in the stock market. Low-income workers are much more affected by higher interest rates on home mortgages than stock market volatility because low-income workers often do not have any stock market investments/portfolios.
- Wage growth and earnings on savings also can offset some effects of inflation.
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Thanks to CNBC.