Inflation creates a ‘money illusion’

Inflation is one of the hardest concepts for an investor to internalize. We tend to think naturally in nominal prices—that is, the price on the sales sticker—rather than the inflation adjusted price.

For instance, which “feels” like the cheaper one-pound loaf of white bread—the one that cost 51 cents in October 1980, or the one that cost $1.04 in October 2005? Both prices, incidentally, came from the U.S. Bureau of Labor Statistics average price lists for those years. Normally we would say 51 cents was cheaper. It was cheaper on a nominal basis, but not on an inflation-adjusted basis. If bread’s price had kept up with inflation, it would cost $1.21 today. In other words, $1.04 is a better price for a loaf of bread today than 51 cents was 25 years ago.

To most of us, however, 51 cents still sounds better. This is called the “money illusion” by researchers who study cognitive phenomena. Besides making it confusing to figure out whether and when you are better off in terms of income and prices, a misunderstanding of inflation can make an investor behave badly.

For instance, for several years now it is likely the average investor has mentally undervalued the interest they have received on bonds and fixed income accounts. Why? Anyone with half a memory can recall the high nominal interest rates paid on bank accounts and Treasury securities in the late 1970s and early 1980s. At that time it was not unusual to be paid 13% on a short-term CD. By 2003 banks were paying as little as 1.2% on the same CDs. But investors who undervalued that 1.2% were forgetting that back in 1980 the inflation rate was 12.4% and income tax rates were higher than in 2003. In 2003 the inflation rate was only 1.9% and income tax rates were lower.

The real return on a CD in 2003—after inflation and after taxes—was virtually the same as it was in 1980. But investors who undervalued the 1.2% return may have decided to seek higher interest rates by acquiring riskier long-term or low-credit-quality bonds. This move would have come back to haunt them in 2005 and early 2006 as interest rates climbed and riskier fixed income investments lost value.