The Federal Reserve set 2% as its long-term inflation target in 2012. According to the St. Louis Fed website, the Fed believes “the economy can run efficiently when inflation is low and stable” and “people can hold money without having to worry that high inflation will erode its purchasing power.” 

The insidious impact on retirees

The loss of 2% of a dollar’s purchasing power over one year does not seem significant. However, consider a couple who retire at age 65 with a $1 million portfolio invested in long-term bonds yielding 5%. If they spend the $50,000 in interest each year, 2% inflation reduces the real purchasing power 45% to $27,500 in 30 years. People need to worry, big time.

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Most retirees have learned to estimate an initial amount to spend from their portfolio that can grow 2% annually without bankrupting them before they turn 95: $30,000 in this case.

That seems truly insidious, but it’s very misleading.

The effect of zero-expected inflation on income

With no long-term expected inflation, retirees should expect to earn 2% less on their portfolio because the nominal long-term bond yield generally reflects the real long-term interest rate plus long-term expected inflation. Then their annual interest should be $30,000. So, no need to worry. Wrong.

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