Damage Calculations

As the United States emerges from the pandemic, the economy is experiencing abnormally high inflation. Will this affect damage calculations? In June, the Consumer Price Index for All Urban Consumers (CPI-U) increased by 0.9%. In May, the CPI-U increased 0.6%.  Over the last 12 months, the CPI-U increased 5.4%. These increases are the highest the index has experienced since 2008. Used cars and trucks, food, and energy prices are experiencing the largest increases1

In the decade before 2020, inflation was relatively stable. From 2010 to 2019, inflation averaged 1.76%, ranging from 0.7% in 2015 to 3.0% in 20112. Although the Federal Reserve has not established a formal inflation target, policymakers generally believe just below 2% is an acceptable level of inflation3.  Investors are unsure if recent price increases are transitory or structural. If higher inflation is transitory, CPI-U will return to acceptable levels in the short term. If higher inflation is structural, higher price increases will continue past the short term. Structural inflation would compel policymakers to respond. 

Will Interest Rates Be Affected?

In response to abnormally high inflation and the possibility of structural inflation, investors are starting to expect the Federal Open Market Committee (FOMC) of the Federal Reserve System will slowly increase the Federal Funds Target Rate in the near future. At the start of the pandemic, the FOMC lowered the Federal Funds Target Rate from 1.50-1.75% to 0.00-0.25%. Interest rate theory suggests that interest rates move together; if the FOMC increases the Federal Funds Targeted Rate, then interest rates across the economy should also go up. How does this impact inflation?

Determining the Net Discount Rate

Future economic damages presented at trial are discounted to present value. To determine the net discount rate, an expert analyzes the relationship between the increasing cost of the future damages and the rate of return between trial and the date the future damages will occur.  In a loss of earnings situation, lost future earnings could be discounted through worklife expectancy. For losses related to future medical care, an expert would discount the cost based on the date the future medical care will occur.

Examining the Net Discount Factor

The net discount factor is a function of time, interest rates, and inflation or wage growth rates. With inflation at its highest point in over a decade, and with the possibility of policymakers responding with higher interest rates, this is an opportune time to reexamine the impact of inflation and interest rates on damages.

Expected inflation determines the price of future damages in nominal dollars4.  As expected inflation increases, the net discount factor will go down and the PV of damages will go up. This is because more money is needed today to fund damages that occur in the future. If the economy is entering a period of structural inflation and all else remains constant (ceteris paribus), the present value of damages will be higher. 

The discount rate is the rate of return used to determine the amount of money needed today to fund future damages. The discount rate moves up and down with other interest rates in the economy. If the discount rate increases as interest rates go up, the present value of damages will decrease, ceteris paribus. This is because a higher rate of return over time means less money is needed today to fund future damages.

Only the future will tell if abnormally high inflation is transitory or structural and whether or not the Federal Reserve will respond by increasing interest rates. Given the current uncertainty of these economic forces, this is an opportune time to reexamine their role in determining the present value of future damages. If you would like guidance regarding future damage calculations, contact our team of experts.

This article was written by Steven Johnson, CPA and Shareholder in the Anderson ZurMuehlen Helena office.

[1] U.S. Bureau of Labor Statistics; Economic New Release, Consumer Price Index Summary, July 13, 2021.

[2] Economic Report of the President, January 2021, Table B-38.

[3] Board of Governors of the Federal Reserve System, Current FAQs, “What is an acceptable level of inflation?”

[4] Nominal dollars are unadjusted for inflation.


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