Why 3% Inflation?

One of the most frequently asked questions about an association’s Reserve Study is why 3% is used as the inflation rate as opposed to the currently published 12 month inflation rate of 1.5%. The answer has more to do with time than it does with current numbers. Specifically, the historical record is a better indicator of a useful inflation rate than the currently published numerical value when it comes to a Reserve Study. So, let’s look a little deeper (and farther back) to understand why 3% is used and why this matters to your association.

The inflation rate is calculated using the monthly Consumer Price Index (CPI) provided by the U.S. Department of Labor Bureau of Labor Statistics. The bureau defines the CPI as:

A measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.

Basically, it tracks how much things cost now vs. what they used to cost. That change in price is inflation (or deflation). The problem is that the CPI is based on a relatively short time horizon, whereas a Reserve Study takes a longer view.

Since a Reserve Study report usually covers thirty years into the future, we cannot use the most current twelve month inflation rate as it will vary (sometimes significantly) from year to year. Instead, we look to the previous thirty years for guidance. Since 1984, the US has averaged 4.14% inflation. Since 1994, inflation has been averaging 2.86%. Looking back at just 2009-2014 the U.S. has been averaging 1.72% inflation. Moreover, the 100 year average since 1913 (when the U.S. Federal Reserve was created and began tracking inflation) has been 3.22%. Clearly, given the variance in the aforementioned time periods, it would be difficult to support an argument in favor of a 1.5% inflation rate over the long term.

Although 1.5%-3% annual inflation doesn’t seem like a big deal, the problem is that it adds up over time. This is called cumulative inflation and it measures the buying power of a dollar over a longer span of time. This means that if you add up 3% inflation for 30 years you get a total cumulative inflation of 90%. So if a product cost $1 now, it would cost $1.90 in thirty years. In the United States, the total cumulative inflation for the last 30 years (since 1984) has been 124.2%. So your $100 good or service from 1984 would now cost you $224.21 for the exact same thing. That’s over double the price in just 30 years!

For a homeowners association, it’s incredibly important to be aware of the future cost of goods and services so that you can adequately prepare for it now. In a worst case scenario, not calculating inflation accurately could lead to future funding deficits of hundreds of thousands of dollars.

Despite economist’s best efforts to forecast with certainty, the biggest challenge is that the future is unpredictable. We just don’t know when another war, drought, natural disaster, or other unforeseen circumstance could arise and result in a drastic increase in prices. The best we can do is look at the past to predict the future. Given that a Reserve Study covers a span of at least thirty years, it’s important to take a wider view of things. This is why, to be safe, most Reserve Study providers use an inflation rate of 3%.

Hard data and statistics in this article were taken from the Bureau of Labor Statistics’ website. Additional information can be found at: “http://www.bls.gov/bls/inflation.htm”