So far in 2022, the most anticipated economic data release has been the monthly Consumer
Price Index (CPI) rate.
While inflation has been steadily increasing since
the market bottomed in March 2020, the most recent reports have shocked consumers.
March’s CPI rate of 7.9% is the highest in over 40 years, and the markets are now expecting rapid rate increases in interest rates from the Federal Reserve.
Use this guide to understand how inflation cuts into personal finances.
A financial advisor in Bountiful, UT, can help to inflation-proof your investments and retirement savings. Keep in mind that tax-efficient financial planning must be part of that strategy.
The basic definition is this – the aggregate increase in prices over time across an economy. Prices of different items are constantly rising and falling, but inflation gauges like CPI and the Producer Price Index (PPI) measure the total rise in price across a basket of goods and services. Over time, inflation eats away at the purchasing power of a currency.
In small doses, this can sometimes stimulate an economy by increasing demand and raising the value of assets. But in large amounts, inflation can cripple and stagnate even the most sturdy economies. Moderate inflation may have some silver lining (which is why the Federal Reserve aims for a 2% rate), but excessive inflation hurts citizens and businesses alike.
Inflation may have a simple definition, but it’s rarely caused by one single event or issue. Many factors have converged over the last few years, and the result is the highest overall inflation in more than four decades. Some of these issues are far beyond the control of a single institution or government, but these bodies can exacerbate the pain.
At its core, inflation is caused by too much money chasing too few goods and services. You can see some of that embedded in the following factors.
When the supply of money increases quickly, inflation is sure to follow— but at the time, policymakers were okay with elevated inflation if it meant keeping the economy from collapsing.
However, when demand returned quicker than expected (edged along by the increase in government spending), consumers had cash but not enough goods and services to spend it on.
Rising commodity prices increase the price of food and fuel – two things American consumers notice with regularity.
Inflation is thought to have three main drivers: cost-push inflation (increasing production costs), demand-pull inflation (increasing demand from households and businesses), and built-in inflation (expectations of inflation push actual inflation up further). You can find a little bit of all three within the current environment, which is why CPI is screaming toward 40-year highs.
High inflation hits everyone participating in the economy, but its effects aren’t evenly distributed. CPI and PPI have different components that rise at different velocities over various time frames.
For example, used cars and other durable goods soared in price in 2021 as demand far outpaced supply. Now that durable prices have stabilized, inflation is beginning to infect commodities and services too.
A decline in purchasing power is the biggest hit every day Americans face during periods of high inflation. If overall inflation is 7.9%, a $100,000 portfolio will lose $7,900 in purchasing power each year. High inflation can act as a de facto tax on consumers that slows demand and hurts economic growth.
When inflation is high, it’s usually up to the Federal Reserve to tame it, and Fed Chair Jay Powell has signaled a willingness to raise rates rapidly. When rates are rising, the cost to borrow money increases, and speculative activity in an economy decreases. In theory, rising rates can reduce inflation since the increased cost of capital will limit demand.
Since inflation hits different areas of the economy more than others, it can often go unnoticed. If you bought a car in 2018, the inflation in used car prices likely did nothing to affect you. But that’s not the case when it begins to affect the price of gas or groceries.
Most Americans fill up their vehicle once every week or so, and everyone needs to visit the grocery store. When gas and groceries get expensive, people notice these recurring costs that can’t be put off.
Prudent investing is crucial during times of high inflation. But this doesn’t mean you should drastically alter your asset allocation or pile into risky commodities or alternative investments. For most investors, the key to making it through inflationary periods is to stay the course and keep investing in assets that preserve purchasing power.
However, if you have the cash to deploy, here are a few investment ideas to consider.
Higher inflation means a higher coupon rate; deflation means a lower coupon rate. TIPS pay interest twice a year. At the end of the term, the owner will receive the adjusted principal or original principal, whichever is higher.
Additionally, TIPS can be sold on the secondary market while I-Bonds cannot. I-Bonds only have a 30-year term available but can be sold after 12 months with a penalty and after five years without penalty.
Physical gold and gold ETFs are great ways to gain exposure to precious metals, although owning physical gold comes with specific storage, trade, and tax concerns.
Stocks don’t exactly blossom when rates are rising and risk appetites are suppressed. Still, a conservative stock portfolio of quality companies can provide investment growth and income through dividends during periods of high inflation.
Real estate deserves its own chapter because property owners have a unique advantage in high inflation. There’s a link between home prices and inflation since inflation often leads to wage increases and higher rates, spurring housing demand and pushing up prices.
Yes, there are some silver livings to inflation, especially for those holding a fixed-rate mortgage.
Mortgage rates reached historic lows during the pandemic, and many homeowners were able to refinance their debt at a rate below 3%. Let’s say you have a $300,000 mortgage that you refinanced last summer at 2.9%. As inflation rises, the cost of financing your debt remains steady at that rate.
Your wages and the price of your home may rise in response to inflation, but the costs of your mortgage won’t. In fact, if inflation is clocking in at 7.9% and you’re paying 2.9% on your mortgage, your real borrowing rate is negative—the mortgage is basically free money!
Plus, your equity has increased since the value of your home has risen as well. It may not be a glamorous investment tool, but a 30-year fixed-rate mortgage is a great thing to have during periods of high inflation.
Inflation is the sworn enemy of the retiree living on a fixed income. Retirees can’t ask for a raise to compensate for inflation; they’ve exhausted their human capital and depend on a nest egg and/or Social Security.
Social Security payments are adjusted for inflation, but this adjustment is done once per year and often lags when inflation spikes. For example, the latest Social Security cost of living adjustment (COLA) went into effect in January, increasing payments by 5.9% for 2022. A 5.9% increase is nice, but it’s already losing purchasing power to inflation when CPI is coming in near 8%.
Goldman Sachs estimates that inflation is expected to taper down to 3.7% by the end of 2022, but this is little solace for retirees when their nest eggs are being stretched thinner than anticipated. To reduce this pressure, retirees can either spend less or make more. And in retirement, ‘make more’ often means taking more investment risk.
Taxes and inflation are the two most significant worries for anyone on a fixed income, but taxes can be planned for and paid efficiently. Generally, people know their given tax rate each year and can maneuver assets into various tax-advantaged accounts to minimize their burden. Unfortunately, there’s no Roth IRA to keep your capital safe from inflation.
We can only make projections and hope they’re accurate.
Inflation is often a personal story because it doesn’t affect everyone equally.
Imagine a homeowner with a fixed-rate mortgage who works from home and doesn’t eat meat. For this imaginary person, inflation has hardly hit them—they own their home, have little need for gasoline, and aren’t affected by price increases in chicken and beef.
Now let’s imagine a renter who has to commute 45 mins each day and just wants to end the evening with a hamburger every now and then—inflation is hitting this person hard.
One benefit of inflation is that wages tend to increase, especially in tight labor markets like the current environment. And wages have indeed been increasing, especially for workers on the lower end of the income ladder who need boosted salaries the most. But wage growth has slowed lately, and the rate of wage gains is not keeping up with the rate of inflation.
However, not everyone suffers when inflation is high. Purchasing power being eaten works both ways—if you have fixed-rate debt like a mortgage or even student loans or credit card debt, your real obligation declines as inflation rises. Look at the previous paragraph for our example of a 30-year fixed-rate mortgage. Fixed-rate debt will be easier to service over time as your income increases, but your borrowing obligation remains the same.
Homeowners and asset holders can also benefit during periods of high inflation if the assets they hold increase in value. If you’re holding cash, you’re currently losing 7.9% each year to inflation. But most people aren’t stuffing money under their mattress or even leaving it in paltry savings accounts earning 50 basis points.
Owners of assets like real estate and stocks will retain more purchasing power if their value increases, even if those increases fail to match the pace of inflation.
We’ve seen investment trends shift drastically over the last 24 months. Rising inflation can throw markets for a loop and change investor sentiment quicker than ever before.
Take the rise in energy stocks in 2021, for example. The energy sector was beaten down and forgotten during the pandemic, but as COVID waned and commodities prices began to increase, energy stocks became one of the best-performing sectors in 2021. If you shifted from tech in 2020 to energy in 2021, you likely didn’t care about accelerated inflation too much.
Keeping pace with changing economic and investment trends can be difficult, but inflationary shocks often create unexpected investment opportunities.
Hiring the right financial advisor is what will make all the difference. And there’s never been a better time to get started or get a second opinion. Your future depends on it.
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Retirement planning is not and should never be a one-time event. Instead, retirement planning is an ongoing process that requires regular adjustments, a comprehensive tax strategy, a sophisticated income plan, and much, much more.
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