In many ways, 2021 was a record-setting year. The S&P 500 accumulated 70 all-time highs over the 12-month period. Unfortunately, that success came with a dark side – the highest rate of inflation since 1982.
As of December 2021, the Consumer Price Index (CPI) was up a full 7 percent – a sharp increase from the low inflation rates the nation has experienced since the 2009 financial crisis. That 7 percent shows up in everything from food and fuel to clothing and cars.
The high rate of inflation means tough choices for consumers because wages aren’t keeping up. In the third quarter of 2021, national wage growth was up just 2.7 percent year-over-year. Many companies have signaled that pay increases will be more robust in 2022 – averaging as much as 4 percent – but that still leaves a gap in purchasing power.
The fact that incomes are not keeping pace with rising prices is exaggerated in 2021, but this issue creates challenges even when inflation rates are low. Even in the best of times, purchasing power risk is one of the biggest threats to building wealth long-term.
What Is Purchasing Power?
At the most basic level, purchasing power is the number of goods and services you can buy for a given amount of money. As inflation pushes prices up, the same amount of money buys less. For example, ground beef priced at $1 in 1970 cost $6.61 in 2021.
To put it another way, ground beef prices have increased more than 560.54 percent since 1970 – an average rate of 3.77 percent per year.
If income hasn’t increased at the same rate, today’s consumers are paying more of their income for the same amount of ground beef. In other words, their purchasing power has declined.
What Affects Purchasing Power?
At an individual level, purchasing power is based on real income – that is, a person’s income adjusted for inflation. Those with higher levels of income have more purchasing power, while those with lower levels of income struggle as prices for housing, food, and transportation rise.
Consider this: the federal minimum wage has been $7.25 since 2009. However, those dollars lost 21 percent of their overall purchasing power in the years since due to inflation.
The cost of housing, healthcare, and other necessities has increased even more than 21 percent, putting people with low incomes in a precarious position.
From a broader perspective, the purchasing power of the nation as a whole depends on the number of people employed and their average rate of pay. Low unemployment means more people earning money, which increases the amount they can spend on goods and services.
It is also worth noting that tax rates can affect a community’s purchasing power, whether on a local, state, or national level. Higher tax rates reduce real income for individuals, which ultimately reduces their purchasing power.
What Is Meant by Purchasing Power of a Customer?
Customer purchasing power comes from income, access to credit, and the cost of non-discretionary items like food and housing.
When businesses consider the purchasing power of a customer, they are estimating the amount their target consumers can pay for a particular product or service.
That’s an important part of the company’s overall strategic plan because it affects pricing and marketing. If the price exceeds the purchasing power of likely buyers, the business will ultimately fail due to lack of demand.
How Does Purchasing Power Affect Price?
Prices are based on supply vs. demand. Sellers attempt to find the precise figure at which they can sell available goods and services without having too many or too few interested buyers. This price point can change based on economic conditions, with prices increasing when consumers have plenty of extra cash and decreasing when budgets are tight.
Lending policy affects price because the more consumers can borrow, the more they are willing and able to pay for a particular purchase. When lenders are highly selective in extending credit, sales of large and discretionary goods and services suffer. For example, many people cannot pay cash for a new car.
An inability to obtain an auto loan reduces their purchasing power. It is also common for travel, entertainment, and other non-critical goods and services to go on credit cards. If credit isn’t available, consumers forgo those purchases.
The housing market is a good example of how purchasing power affects price. In 2021, far fewer homes were available for purchase – a lack of supply – which forced prices up. Buyers who were willing to pay those higher prices could get the loans they needed to do so, as mortgage interest rates were quite low, and banks were ready to lend to buyers with basic qualifications. This created enough demand to support the higher home prices.
What Risks Reduce Purchasing Power?
Inflation is the biggest risk to purchasing power. However, it is worth noting that currency exchange rates can also affect prices, which in turn reduces purchasing power. This occurs because businesses that rely on international suppliers face their own issues with reduced purchasing power when the dollar loses value.
Though the international vendors haven’t changed their prices, businesses pay more when the dollar grows weaker. That can push prices higher – and lower purchasing power – for the consumers who ultimately buy the finished products.
What Is PPP Formula?
Understanding how purchasing power compares across geographies can be difficult when multiple currencies are involved. The solution is a metric known as Purchasing Power Parity (PPP) that allows economists to examine standards of living and economic productivity between two countries.
The formula for calculating PPP is the cost of the item(s) in currency 1 / the cost of the item(s) in currency 2. Generally, economists interested in making broad comparisons pull together a basket of goods that represent common purchases – food, clothing, and similar. However, for simplicity, this example uses a single item:
If a pair of pants costs $20 in the United States, and the same pair of pants costs €16.00 in France, which consumer is paying more for the clothing? The €16.00 must be converted to US currency to find the answer.
If, in this example, €16.00 converted to $21, the PPP would be $21/$20 or 1.05. To look at it another way, US consumers have greater purchasing power, as the pants are 1.05 times more expensive in France.
Examples of Purchasing Power Risk
It’s one thing to balance income and purchasing power while still in the workforce. Promotions, bonuses, and career moves can ensure total purchasing power keeps pace with inflation. However, when income is based on a lifetime of saving, for example, after retirement, there is serious risk to purchasing power long-term. This may be the biggest example of purchasing power risk.
Standard savings accounts, certificates of deposit, and other risk-free methods of holding cash pay very little interest. Even when inflation is low, those interest rates can’t keep up. When it is time to retire, the accumulated cash has lost much of its purchasing power, though – on the surface – it seems that the account holder did everything right.
Choosing investments with an eye on mitigating purchasing power risk is a must for building long-term wealth.
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