- \ Gerard Gruber
- June 23, 2021
After more than a decade of near dormancy, inflation appears once again to be bubbling near the surface. Whether it continues to gradually percolate or turn into a gusher is the subject of debate...
After more than a decade of near dormancy, inflation appears once again to be bubbling near the surface. Whether it continues to gradually percolate or turn into a gusher is the subject of debate among economists. What we do know is that pandemic-induced, massive government spending and easy monetary policy from the Federal Reserve is the perfect brew for an inflationary surge. Should that happen, once the genie is out of the bottle, it won’t be easy to get it back in.
The Current State of Inflation
For several years, the Federal Reserve has been “targeting” just over 2% inflation, meaning that is the rate at which the Fed feels it can control inflation, while preventing a slide into deflation, which can be much more devastating to the economy. For most of the last several years, inflation has averaged less than 2%, falling as low as zero in 2020. Mild inflation—in the 2 to 3% range—can actually be healthy for the economy.
As recently as March 2021, the fed was projecting a 2.4% annual inflation rate for the year. With the more recent sharp spike in May, the Fed has bumped up its projection to 3.4%, which would be the highest in 11 years. But it continues to attribute the recent spike to pandemic-related issues, such as the abnormal rise in lumber prices and used cars, with the likelihood that inflation would settle back down to the 2% range.
The Effects of Inflation on Your Finances
While it may be too soon to know whether the recent spike in inflation is merely transitory—an overreaction to the sharp economic rebound—or a more sustainable trend, consumers are definitely feeling it. Prices at the checkout counter and the gas pump are rising faster than they have in more than a decade. For many people who have never experienced high inflation, it can be unsettling. For those near or in retirement, who did experience the double-digit inflation of the late 1970s, early 1980s, it can be downright scary.
Though they could take years to unfold, the full-scale effects of sustained inflation are unmistakable:
- Increasing prices of goods and services leaving less money available for savings
- Erosion of purchasing power. A 7% inflation rate would reduce your purchasing power by half in just ten years.
- Reduce the value of savings. If your savings interest rate is less than the inflation rate, you are, in effect, losing money.
- Increasing borrowing costs. The Fed’s primary defense against rising inflation is to hike interest rates.
Inflation is Not All Bad
While inflation can wreak havoc on your personal finances, there are some perceivable positive aspects. While you will pay more for goods and services, your wages are likely to increase due to cost-of-living increases. Social Security benefits are indexed to the rate of inflation. And, while you could see the value of your savings decline, it’s an incentive to move more of your money into stocks, which have historically outpaced inflation.
Steps to Prepare for an Inflationary Environment
Still, consumers and investors would be wise to account for the possibility of higher inflation in their financial plans.
First, don’t liquidate your assets. Moving your money to cash or cash equivalents will ensure a loss of purchasing power. Except for a moderate amount of money in an emergency fund, you should also reconsider savings accounts that earn less than the inflation rate.
Second, reconsider fixed income investments, such as government and corporate bonds, and bond funds are also vulnerable to inflation. Because inflation can erode the purchasing power of future cash flows, the value of fixed-income investments tends to decrease. Bond yields will rise, resulting in lower bond prices. Longer-term investment-grade bonds are more effected than shorter-term bonds. Lower-grade, high-yield bonds are also less effected because of their higher interest payouts.
You may want to consider increasing your exposure to Treasury Inflation-Protect Securities (TIPS) because their interest rates are adjusted based on the inflation rate.
Finally, maintain a properly diversified portfolio. For investors in it for the long haul, a well-diversified investment portfolio should be able to weather the economic cycles. There is no perfect inflation hedge, but it wouldn’t hurt to incorporate some inflation-ready investments.
Historically, equities have performed well in inflationary environments. For the last three decades, U.S. stock prices have risen during periods of accelerating inflation. That’s because equities are productive assets. Larger, high-quality companies with strong brands and competitive positions are able to increase prices and grow their profit margins. Although mid-sized companies don’t fare as well as larger companies, they can outperform smaller companies during periods of prolonged inflation.
You may also want to consider adding hard assets to your portfolio. Physical assets such as metals, commodities have a more direct correlation with inflation, but they tend to be volatile so don’t go overboard. Real estate is also considered a potentially safe haven from inflation. If you don’t want to own real property, you could add some real estate investment trusts (REITs) to your portfolio.
Remember that specialty sectors like commodities and REITS have additional risks that may be greater than those associated with more traditional investments such as blue-chip stocks. You should carefully consider risks such as limited liquidity, tax considerations, and speculative investment strategies including leverage and commodity price volatility.
Bottom Line
Although an inflationary surge is not a foregone conclusion, consumers and investors would do well to fortify their finances and investments against the possibility. By making some small adjustments now, you won’t be caught off guard when high inflation does strike. It’s important to remember that inflation never goes away (unless we experience deflation, which wouldn’t be good either). Whether inflation is mild or raging, we always have to account for it and its long-term impact on our finances.