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By Michael J. Wiener
As we’ve learned in recent years, inflation can rise up and make life’s necessities expensive. Despite the best efforts of central bankers to control inflation through the economic shocks caused by Covid-19, inflation rose significantly for nearly 3 years in both Canada and the U.S.
Uncertainty about future inflation is an important risk in financial planning, but most financial planning software treats inflation as far less risky than it really is. This makes projections of the probability of success of a financial plan inaccurate. Here we analyze the nature of inflation and explain the implications for financial planning.
Historical inflation
Over the past century, inflation has averaged 2.9% per year in both Canada and the U.S.(*) However, the standard deviation of annual inflation has been 3.6% in Canada and 3.7% in the U.S. This shows that inflation has been much more volatile than we became used to in the 2 or 3 decades before Covid-19 appeared. In 22 out of 100 years, inflation in Canada was more than one standard deviation away from the average, i.e., either less than -0.7% or more than 6.5%.(**) Results were similar in the U.S.
Historical inflation has been far wilder than the tame inflation we experienced from 1992 to 2020. And the news gets worse. Within reason, a single year of inflation is not a big deal to a long-term financial plan; what matters is inflation over decades. It turns out that inflation is wilder over decades than we’d expect by examining just annual figures with the assumption that each year is independent of previous years.
The standard deviation of Canadian inflation over the twenty 5-year periods is 14%, and over the ten decades is 27%. Based on assuming independent annual inflation amounts, we would have expected these standard deviation figures to be only 8% and 11%. How could the actual numbers be so much higher? It turns out that inflation goes in trends. This year’s inflation is highly correlated with last year’s inflation. Rather than a correlation of zero, the correlation from one year to the next is 66% in Canada and 67% in the U.S.(***)
Even successive 5-year inflation samples have a correlation of 60% in Canada and 56% in the U.S. It’s only when we examine successive decades of inflation that correlation drops to 23% in Canada and 21% in the U.S. This is low enough that we could treat successive decades of inflation as independent, but we can’t reasonably do this for successive years.
How relevant is older inflation data?
Some might argue that old inflation data isn’t relevant; we should use recent inflation data as more representative of what we’ll see in the future. After all, central banks had a good handle on inflation for a long time. Let’s test this argument.
From 1992 to 2020, inflation in Canada averaged 1.72% with a standard deviation of 0.94%. Using this period as a guide, the inflation that followed was shocking. In the 32 months ending in August 2023, inflation was a total of 15.5%. Using the 1992 to 2020 period as a model, the probability that the later 32 months could have had such high inflation is absurdly low: about 1 in 10 billion.(****)
It may be that older inflation data is less relevant, but our recent bout of inflation proves that the 1992 to 2020 period cannot reasonably be used as a model for future inflation. There is room for compromise here, but any reasonable model must allow for the possibility of future bouts of higher inflation.
Implications
It’s important to remember that once a bout of inflation has been tamed, the damage is already done. Prices have jumped quickly and will start climbing slower from their new high levels. If there has been 10% excess inflation over some period, all long-term bonds and future annuity payments will be worth 10% less in real purchasing power than our financial plans anticipated. This is a serious threat to people’s finances.
We often hear that government bonds are risk-free if held to maturity. This is only true when we measure risk in nominal dollars. Because spending rises with inflation, our consumption is in real (inflation-adjusted) dollars. Bonds held to maturity are exposed to the full volatility of inflation. We need to acknowledge that bonds have significant risk. Only inflation-protected government bonds are free of risk. Continue Reading…
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