Adjusted future inflation rate: Meaning, Criticisms & Real-World Uses

What Is Adjusted Future Inflation Rate?

The adjusted future inflation rate refers to the concept of modifying financial calculations and expectations to account for the anticipated erosion of Purchasing Power due to Inflation over a specified future period. It is a crucial concept within Macroeconomics and financial analysis, allowing individuals and institutions to assess the true value of money, investments, and returns in real terms, rather than in nominal, unadjusted terms. While not a single, universally published rate, the idea of an adjusted future inflation rate underpins the calculation of metrics like the Real Interest Rate and real Investment Returns.

History and Origin

The concept of accounting for inflation's impact on financial outcomes has roots in economic thought, notably crystallized by economist Irving Fisher. His work led to the articulation of the Fisher Effect, a theory describing the relationship between nominal interest rates, real interest rates, and expected inflation. Fisher's contributions in the early 20th century highlighted that a Nominal Interest Rate reflects both the real cost of borrowing or the real return on investment and the expected rate of inflation over the life of the loan or investment.

The practical application of adjusting for future inflation became even more pronounced as economies experienced periods of significant price increases. For instance, the high inflation periods of the 1970s and early 1980s underscored the necessity of understanding real returns, as nominal interest rates often failed to keep pace with the rising cost of living, leading to negative real returns for savers. This historical context emphasized that neglecting the adjusted future inflation rate can lead to a misjudgment of economic well-being and investment performance.

Key Takeaways

The adjusted future inflation rate is a conceptual approach to account for expected inflation when evaluating financial figures.
It is essential for determining the true Purchasing Power of money and investment gains over time.
The concept is foundational to understanding Real Interest Rates and real Investment Returns.
Forecasters regularly provide projections that inform calculations of the adjusted future inflation rate.
Ignoring the adjusted future inflation rate can lead to an overestimation of actual wealth growth and financial stability.

Formula and Calculation

The adjusted future inflation rate is typically incorporated into calculations of real interest rates or real returns. The fundamental formula, often referred to as the Fisher equation (or a more precise version), adjusts a nominal rate by the expected future inflation rate.

The approximate formula for the real interest rate or real return is:

$\text{Real Rate} \approx \text{Nominal Rate} - \text{Expected Inflation Rate}$

A more precise formula, especially when dealing with higher rates, is:

$\text{Real Rate} = \frac{(1 + \text{Nominal Rate})}{(1 + \text{Expected Inflation Rate})} - 1$

Where:

Real Rate: The rate of return or interest after accounting for inflation's impact on Purchasing Power.
Nominal Rate: The stated or advertised rate of interest or return before considering inflation. This could be a bank's interest rate, a bond's yield, or an investment's stated return.
Expected Inflation Rate: The anticipated rate at which the general price level of goods and services will increase over the period. This is often derived from forecasts, such as those published by the Survey of Professional Forecasters ¹⁶, ¹⁷.

Both the nominal rate and the expected inflation rate should be expressed as decimals in these formulas.

Interpreting the Adjusted Future Inflation Rate

Interpreting calculations that incorporate the adjusted future inflation rate involves understanding the true economic impact of financial figures. When an investor evaluates an asset's potential Investment Returns, factoring in the adjusted future inflation rate reveals whether the investment is genuinely increasing their Purchasing Power or simply keeping pace with rising prices.

A positive real rate indicates that the nominal return exceeds the rate of inflation, leading to an actual increase in wealth. Conversely, a negative real rate means that inflation is eroding wealth faster than the nominal return is generating it. For example, if a savings account offers a 1% Nominal Interest Rate and the expected future inflation rate is 2%, the real interest rate is approximately -1%. This implies that despite earning interest, the money in the account will buy less in the future than it does today. This perspective is vital for sound Financial Planning and long-term investment strategies.

Hypothetical Example

Consider an individual planning for retirement. They have a diversified portfolio that historically generated an average Nominal Interest Rate of 7% per year. To determine the real growth of their savings, they need to account for the adjusted future inflation rate.

Suppose economic forecasts suggest an average annual inflation rate of 3% over the next decade, as measured by the Consumer Price Index (CPI).

Using the precise formula for the real rate of return:

$\text{Real Return} = \frac{(1 + 0.07)}{(1 + 0.03)} - 1$
$\text{Real Return} = \frac{1.07}{1.03} - 1$
$\text{Real Return} \approx 1.03883 - 1$
$\text{Real Return} \approx 0.03883 \text{ or } 3.883\%$

In this hypothetical example, while the nominal return is 7%, the real return, adjusted for future inflation, is approximately 3.883%. This means that the individual's savings are expected to increase in actual Purchasing Power by about 3.883% each year, rather than the full 7% nominal gain. This insight allows for more realistic retirement planning and wealth accumulation goals.

Practical Applications

The concept of an adjusted future inflation rate is fundamental across various areas of finance and economics.

Investment Analysis: Investors use it to evaluate the true profitability of various assets like Bonds, stocks, and real estate. For instance, bond yields need to be assessed against expected inflation to understand the real return bondholders will receive.
Financial Planning: Individuals and financial advisors factor in anticipated inflation to set realistic goals for retirement savings, college funds, and other long-term financial objectives. This ensures that future purchasing power is maintained or enhanced.
Corporate Finance: Businesses consider the adjusted future inflation rate when making capital budgeting decisions, evaluating potential projects, and forecasting future revenues and costs.
Monetary Policy: Central Banks, such as the Federal Reserve, closely monitor inflation expectations to guide their interest rate decisions and maintain price stability as part of their dual mandate for stable prices and maximum employment. The Federal Reserve Bank of San Francisco has published research analyzing the causes of inflation, including the impact of fiscal support measures¹⁴, ¹⁵.
Government Borrowing: Governments issuing Treasury Securities and other debt instruments are keenly aware of how inflation expectations influence the real cost of their borrowing. Inflation-indexed bonds (like TIPS in the U.S.) are designed to protect investors from inflation by adjusting their principal value based on the Consumer Price Index (CPI).

Understanding the adjusted future inflation rate helps in making informed decisions that account for the changing value of money over time, a critical element for sustainable Economic Growth.

Limitations and Criticisms

While vital, calculations involving an adjusted future inflation rate have inherent limitations. The primary challenge lies in the accuracy of future inflation forecasts. Forecasting inflation is complex, influenced by numerous factors, including global economic conditions, supply chain disruptions, government policies, and consumer behavior¹², ¹³. Forecasts, such as those provided by the Survey of Professional Forecasters, represent expert consensus but are not guarantees¹⁰, ¹¹. Unexpected events, like geopolitical conflicts or unforeseen economic shocks, can significantly alter the actual inflation trajectory, leading to discrepancies between the expected and realized inflation rates⁸, ⁹.

Another limitation is the choice of inflation measure. Different indices, such as the Consumer Price Index (CPI) or the Personal Consumption Expenditures (PCE) price index, can yield slightly different inflation rates, impacting the adjusted figure⁶, ⁷. Furthermore, the average inflation rate might not reflect an individual's personal inflation experience, as specific consumption baskets vary⁵.

Finally, the simple approximation of the Fisher equation might not be accurate during periods of very high inflation or very high nominal interest rates, where the precise formula becomes more relevant. This highlights that while the concept is powerful, its practical application requires careful consideration of its underlying assumptions and the inherent uncertainties of economic forecasting.

Adjusted Future Inflation Rate vs. Real Interest Rate

The "Adjusted Future Inflation Rate" is not a rate in itself but describes the process and outcome of accounting for anticipated price level changes. The Real Interest Rate, on the other other hand, is the specific result of adjusting a Nominal Interest Rate for inflation, often using an expected future inflation rate.

The confusion often arises because the calculation of a real interest rate inherently involves the concept of an adjusted future inflation rate. The real interest rate is what an investor or lender truly earns, or a borrower truly pays, after the effects of inflation have been stripped away. It represents the change in Purchasing Power. Therefore, when one refers to an "adjusted future inflation rate" in the context of financial returns or costs, they are generally referring to the inflation component that has been factored into deriving the real interest rate or real return. The Fisher Effect explicitly connects these two, stating that the nominal interest rate tends to equal the real interest rate plus the expected inflation rate⁴.

FAQs

Q: Why is it important to consider an adjusted future inflation rate?
A: It's important because Inflation erodes the value of money over time. By adjusting for expected future inflation, you can understand the true growth of your investments and savings in terms of Purchasing Power, rather than just the nominal increase in monetary value. This is crucial for long-term Financial Planning and preserving wealth.

Q: Where can I find information about future inflation rates?
A: Future inflation rates are typically found in economic forecasts. Reputable sources include the Survey of Professional Forecasters published by the Federal Reserve Bank of Philadelphia, as well as reports from the International Monetary Fund (IMF) and other economic research institutions. These provide median expectations for future inflation², ³.

Q: Can the adjusted future inflation rate be negative?
A: When we discuss the "real rate" which is "adjusted" for future inflation, yes, the real rate can be negative. This occurs when the Nominal Interest Rate or nominal return is lower than the expected future Inflation rate. A negative real rate means that your money's Purchasing Power is declining, even if you are earning a positive nominal return. This is also why some investors look for investments with a positive Risk-Free Rate after adjusting for inflation.

Q: How does the adjusted future inflation rate impact my savings?
A: If the interest rate on your savings account does not keep pace with the adjusted future inflation rate, the real value of your savings will diminish over time. This means that while the number in your account might grow, its ability to buy goods and services in the future will decrease. To maintain or grow your Purchasing Power, your Investment Returns need to exceed the expected inflation rate.

Q: Is there a difference between "adjusted future inflation rate" and "inflation-adjusted return"?
A: The phrase "adjusted future inflation rate" refers to the concept of taking future inflation into account. An "inflation-adjusted return" is the result of applying this concept to an investment's nominal return, yielding the Real Interest Rate or real rate of return¹. They are closely related, with the former being the conceptual framework for calculating the latter.