Beware of the money illusion, particularly when inflation and interest rates are moving.
First coined by economist John Maynard Keynes, the money illusion states that the average person tends to view their wealth and income in nominal terms instead of real terms. (Irving Fisher gets credit for later adding some intellectual heft to this idea). The theory states that we view the value of a dollar in fixed terms, when its real value is always in flux.
Essentially, we may overlook inflation when making a host of financial decisions, from saving for retirement to buying a home. While it remains a debated theory (people are more rational than economists give them credit for), it’s worthwhile to understand it.
What’s real versus nominal value?
Nominal value is not the same as real value. A 5 percent raise is solid when inflation is 1 percent because your real earnings grew 4 percent, but if inflation is 6 percent your real earnings declined 1 percent —even with a raise. To the hypothetical person who only sees nominal values, that 5 percent raise was equal in both cases.
The money illusion can throw financial decision-making for a loop because it quietly operates in the background. For example, a savings account is the safest place for cash, but even here it’s not perfectly immune from all economic risks. Even if you don’t make a single withdrawal, the real value of your savings will decline when inflation exceeds the interest you earn because every dollar saved can purchase a little less as time goes on. Keeping pace with inflation, therefore, is a big focus for retirees who are living off their savings.
Let’s say you purchased a home for $250,000 a decade ago and insured it accordingly. Today, your home’s value has risen to $320,000 and inflation is in an uptrend. Does your home insurance policy cover the nominal or real value of your home? Rising material and labor costs will also inflate the overall price tag of replacements and repairs.
Anytime you are borrowing or investing for your future, the money illusion is in play. That’s particularly the case when inflation or interest rates are on the move, as this can stretch the “spread” between rates and inflation. However, keeping nominal and real values top of mind in your financial life can help you avoid paying too much for debt or help you generate sufficient, risk-adjusted returns on your savings and investments over time.
Here’s how to keep the money illusion from distorting your finances.
How to combat the money illusion in your life
View savings like a business
When a business produces a widget for $10 and sells it for $15, it earned $15 in revenue; however, the business earned $5 profit accounting for those input costs. Apply this same basic thinking to your personal finances, but instead of a widget your product is your savings, and the input cost is inflation.
You want to run a profitable business over the long run, which means saving and growing your overall net worth at a pace that exceeds your input cost, inflation. To be clear, you may not even notice modest inflation from one year to the next. Inflation may be high one year and decelerate in the next. However, the cumulative effect of inflation (along with taxes etc.) over decades is where it more noticeably impacts wealth accumulation.
To keep the money illusion at bay, make a point to lookup the inflation rate periodically through the year. That doesn’t mean altering your financial plan each month based on inflation; rather, use the inflation rate as a mental reference point when you’re thinking about saving, making a big purchase, borrowing or investing.
Value is relative, not independent
Everything in the economy is interrelated, no asset is an island (unless it’s literally an island). The rate on a mortgage or student loan depends on an intricate dance between the markets, the Federal Reserve, Congress, inflation, interest rates and a host of other factors. Everything is interconnected, which means the real value of any single asset depends on its value in relation to a host of others.
For example, in 1981 a savings account could earn 13 percent interest every year, which absolutely crushes current rates. But in 1981 inflation was also 10 percent and the typical mortgage rate hovered around 16 percent. Relative to other factors, that 13 percent interest earned in a savings account doesn’t appear so impressive.
Have a financial plan
Finally, the last way to combat the money illusion is to have a financial ally in your corner. A financial advisor can build a long-term strategy that provides cash to fund the things you want to do today, while putting the rest of your income to work on your goals.
A financial advisor makes it their job to track markets, prevailing interest yields, monetary and fiscal policy and more so you don’t have to. If you stick to the plan, you can feel confident that you’re taking care of today and tomorrow. Forget illusions, that’s a money reality worth striving for.