To the surprise of most consumers, the rate of inflation rose by a miniscule 0.1% in 2008, the smallest calendar-year increase in the consumer price index since 1954 and a marked decline from the 2007 inflation rate of 4.1%. The near-zero rate was a rapid reversal just a few months after inflation reached 17-year highs.

Although most Americans will welcome lower prices on a variety of items after a turbulent 2008, the steep price drops also raised concerns for the already flagging economy.

The continuing saga of consumer prices is not as simple as the year-end statistical reading suggests. It would be a mistake to assume that inflation is under control and that deflation is the marquee threat to your long-term financial outlook.

A Closer Look at CPI
The consumer price index, or CPI, is probably the most-watched inflation measure. The U.S. Bureau of Labor Statistics compiles the index by measuring changes in the prices of common goods and services such as food, clothing, energy, and housing. Each price category is weighted according to its contribution to the index, so that a spike in housing costs might have a greater effect on the index than a spike in food or clothing prices.

In a year that saw fuel prices rise higher and faster than ever before, how could the consumer price index end up essentially flat for the year? In fact, much of the CPI’s reversal in 2008 can be attributed to a stunning 21% decline in energy prices toward the end of the year. Energy price declines were driven by a roughly 75% decline in oil prices from a July peak. Just six months after Americans were paying record gas prices averaging $4.11 per gallon, gas prices ended the year down 43%. Transportation prices were down 13.3%.

It’s worth noting that the price of oil directly affects other prices throughout the economy. That’s because oil is the U.S. economy’s common denominator. Think for a moment about the products and services you use on a regular basis. Can you name any that do not rely in some way on oil to get to market?

Some economists have suggested that as the recession set in and demand for oil fell, plummeting gas prices actually left more money in the hands of consumers, the positive effect of which was roughly equal to a $200 billion tax cut.

However, not everything escaped inflation. Housing, tuition, food, medical care, recreation, and communication costs continued to rise in 2008.

A Persistent Threat
Rapidly falling inflation has generated some fear that deflation is now a dominant threat. Deflation is a downward cycle in which prices fall, usually because of a decline in available credit or the money supply. The cycle can be exaggerated by fearful consumers who cut back on spending. The resulting contraction in demand can cause unemployment, which in turn can further damage consumer spending as those who are laid off cut back on spending, which can further damage businesses and result in more layoffs.

It’s true that the threat of deflation in the short term could potentially prove dangerous for the economy. However, Federal Reserve officials say they do not foresee the likelihood of a sustained period of deflation, although they expect prices could fall further. As long as price decreases stay tied to energy and commodities, the net effect could remain mostly positive.

Deflation is actually quite rare and any bouts are usually fairly short. Since 1913 (the earliest year for which CPI data is available), only 11 calendar years ended with a negative inflation rate, the last one in 1954.

By contrast, inflation has reduced the spending power of a dollar in 84 of the 95 calendar years since 1913. Although rising inflation may not seem to be a factor at the present time or even in the near future, investors should not ignore the more consistent threat of inflation over the long term.

Since 1979 (when the inflation rate was an astounding 13.3%) the annual inflation rate has averaged about 3.8%. At that rate, the purchasing power of a dollar is cut in half about every 18 years. Left unchecked, inflation erodes the purchasing power of your retirement portfolio, increasing the risk that you will run out of money or be forced to moderate your lifestyle.

Not a Good Reflection on You
The 2008 inflation rate may help confirm your suspicion that the headline inflation rate doesn’t always reflect changes in your personal spending. The real danger in relying too much on the CPI is that you may actually underestimate how your spending will grow over time.

The CPI is a statistical tool used to help make projections and measure change. But CPI calculations are based on a diverse set of households, so they cannot reflect the economic reality of any one household. For example, the CPI does not reflect consumption behavior. Spending habits tend to vary by age — the average retiree probably spends more on medical expenses than the average college student. Spending habits can also vary by region — consider the cost of living in Chicago versus Oklahoma City.

Likewise, the CPI cannot measure your personal spending habits. How often do you shop at discounters versus premium retailers? Do you always buy the lowest priced item, or do you buy what you want even when a cheaper substitute is available? The CPI also fails to capture the effects of induced consumption, which is the tendency to spend more as your disposable income rises.