Following a year of economic instability, mainstream attention is turning to something that’s been around for decades, but has recently piqued national interest - inflation. A recent study found that people are Googling the word “inflation” at a peak not seen since 2008.1
Since the start of the COVID-19 pandemic, six major stimulus bills totaling around $5.3 trillion have passed. With these efforts to alleviate pandemic-fueled financial strife, many are wondering how inflation levels are being impacted by all this extra money being pumped into the economy.
As you consider any potential changes to inflation we may be seeing this year, here’s a guide about what inflation is and how it can affect you.
What Is Inflation?
Inflation is defined as an upward movement in the average level of prices. I like using coffee as an example:
While prices can rise for many reasons, inflation happens when there are too many dollars chasing too few goods or services. When large quantities of money are created and put into the economy too quickly, the dollar loses its value, causing prices to go up. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.
Understanding the Consumer Price Index
The CPI was developed based on information provided by families and individuals on purchases made in the following categories:3
- Food and beverages
- Medical care
- Education and communication
- Other groups and services
While it’s the commonly used indicator of inflation, the CPI has come under scrutiny as it doesn't always tell the whole story. For example, the CPI rose 1.4 percent between January 2020 and January 2021 – a relatively small increase. A closer look at the report, however, shows the movement in prices on various goods was not all equal.
You've no doubt noticed the higher prices in gasoline and oil going well over 1.4%, and used car and truck prices rose more than 10% during those 12 months and beyond.4
Taking other increases like these into consideration, the global year-over-year increase in CPI inflation is closer to 5.4%.
Effects of Inflation
Why is high inflation a big deal? Because inflation can impact your finances and investments in several ways. Most notably, it can reduce the rate of return and decrease purchasing power (how much stuff your money can actually buy).
Rate of Return
Inflation reduces the real rate of return on investments. Say an investment earned 6% over a 12-month period. During that time, let's say inflation averaged about 1.5%. That would mean that your investment’s real rate of return would have been 4.5%- not six percent.
This concept becomes even more critical when applied to money parked in low-interest checking and savings accounts.
For example, if year over year inflation is 5.4%, and you have a large chunk of money sitting in a checking account earning 0.01%, then you are actually earning a negative return on your money, no different than if your account declined by -5.3% in value. This is because your dollars now purchase -5.3% less than they did the previous year, which is why economists call high inflation the "silent killer" of wealth.
To expand on the point above, inflation puts your purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer goods and services:
One dollar back in 1944 would buy you 20 bottles of Coca-Cola, but now that same dollar will only get you a McDonald's coffee.
Increased investor concerns about inflation are justified because the effects of unchecked inflation on purchasing power can be devastating. The loss of purchasing power over the last decade — a period when U.S. inflation has been benign and stable, averaging 1.7 percent per year—reduced $100 at the beginning of 2011 to roughly $85 dollars by the end of 2020. If a decade of below-average inflation can have that kind of effect on purchasing power, imagine what could happen if the current trend continues.
If we have 5.4% inflation for the next decade, inflation will reduce that same $100 of purchasing power to roughly $60 of purchasing power after ten years. It is no wonder investors are scrambling to protect their portfolios.
What's the likelihood of that happening? Trying to predict where inflation goes from here is excruciatingly difficult. It may go higher, or it may settle back to a 2.5-3.0% historical average (the most likely scenario). There's just no way to reliably forecast it. If you ask ten different economists you will get ten different answers. If you like economic data and are up to digging into a technical analysis of inflation possibilities, Cullen Roche provides a very good one here.
How to Protect Against Inflation
When seeking inflation protection, it is important to make the distinction between short-term assets and assets that outpace inflation over the long term.
For short-term assets like savings and emergency funds, I lean toward using money market savings accounts (NOT money market mutual funds, these can lose value). They are FDIC insured and offer much higher rates of interest than regular checking or savings accounts.
The average money market account rate is around 0.50% right now. If inflation stays at 5.4% your savings is still taking a beating, but 0.50% is much better than 0.01%. Another advantage is when overall interest rates inevitably increase, money market accounts are also more likely to increase their rates quicker than ordinary checking or savings accounts do.
What About Gold?
Isn't gold a great inflation hedge?
In a nutshell, no. Gold has little correlation with inflation and has failed to keep up with it over the last few decades. From the beginning of 1980 to the beginning of 2000, the price of gold dropped more than 40% while the CPI rose almost 120%. Yikes.
Tracking the performance of gold in 2021 (using GLD) isn't any more encouraging. As of today, it's down almost -5% for the year. This is telling, especially when inflation was expected and continues to rise. This tells us gold is not quite as popular as it's made out to be (this also may be due to former gold buyers going to cryptocurrencies instead, but that's just me speculating and outside the scope of this article).
It's also worth noting a little-known fact – the US government has actually confiscated gold from its citizens in the past. In 1933, President Roosevelt's Executive Order 6102 required U.S. citizens to deliver on or before May 1, 1933, all but a small amount of gold coin, gold bullion, and gold certificates owned by them to the Federal Reserve or face up to ten years in prison.5
When the dollar is weakening, using other stores of value (like gold) can cause the dollar to weaken further, exacerbating the problem. The government in this case was essentially forcing people to use the dollar in an attempt to keep it from declining even further in value. While this was a rare event, it did happen and could always happen again, which strengthens the case against holding physical gold or investing in it indirectly.
Inflation and Your Investments
If you are worried about inflation and the investments in your 401k or IRA, the recent paper US Inflation and Global Asset Returns by Wei Dai and Mamdouh Medhat provide some helpful insights.
They studied the relation between US inflation and the performance of global asset classes (bonds, stocks, commodities, and real estate), both over a long sample period (1927–2020) and over the most recent 30 years (1991–2020).
Here are the practical takeaways:
- While energy and commodities delivered higher average returns in high-inflation years compared to low-inflation years, they have been much more volatile than inflation, and most of the difference in the returns was unrelated to inflation. This suggests it's a bad idea to try and "time" inflation by making bets on these sectors.
- Most of the assets studied have been able to outpace inflation over the long term. This implies that simply being invested in a diversified portfolio may be the most practical and effective long-term solution when it comes to inflation.6
This result may be surprising to some, but it's hard to argue with the data.
To illustrate this, here’s a look at the calendar year returns on the S&P 500 along with the annual inflation rate going back to 1928:
Notice that even when inflation has been as high or higher than it is right now, the stock market has held up pretty well in the past.
Here’s a table that ranks the highest calendar year rates of inflation with the corresponding returns on the stock market:
The average returns for the S&P 500 in these years were close to 9.4%. That’s basically the long-term average over the market's history. Almost half of these years were double-digit returns, and nearly one-third of the time, returns were over 20% when inflation was the highest.7
It makes sense that the stock market would rise in an extended inflationary environment. When costs rise, companies pass that on to you through increases in the price of their goods. Prices go up, but so do their profits and corresponding share prices.7
Now that we've defined the risks and looked at some data, am I saying you should go out and throw more money in the stock market to keep pace with inflation?
No. As with all things financial, the best approach for you is one that is personalized and tailored to your individual situation. Keep in mind that in the short-term, the market can and will be volatile, especially if inflation continues to rise. Your strategy should be dependent on your long AND short-term goals and your personal ability to handle risk.
I would be cautious though about keeping too much of your money in checking or savings accounts, as those will be hit the hardest with high inflation. If you have an adequate emergency fund but tend to save more and more cash, consider alternatives so you aren't consistently losing purchasing power.
The main takeaway is when it comes to inflation, risk is ultimately forced upon us, whether we put our dollars under our mattress or in the market. You're essentially forced to choose and balance one risk (loss of purchasing power through inflation) versus another (volatility in the market).
If you have questions on inflation or want to look at what approach might make sense for you, reach out to me and I'll be happy to help.
This content is developed from sources believed to be providing accurate information. The information presented herein is for educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security or recommendation of an investment strategy.
Certain information may be based on third-party data which may become outdated or otherwise superseded without notice. Third-party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Please consult legal, financial, or tax professionals for specific information regarding your individual situation.
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