Understanding Inflation

By Mitchell J. Smilowitz, CPA

Inflation has been around forever, but the rate of inflation in most developed economies has been extremely low for the last few decades, about 2% a year. While roughly half of the 14% inflation we saw in 1980, inflation increased to 7.5% in 2021.  

How worried should we be?

What Is Inflation?

Inflation is a loss of purchasing power over time; it means your dollar will not go as far tomorrow as it did today.

Inflation is typically expressed as the annual change in prices for a basket of goods and services. The Consumer Price Index, or CPI, measures the cost of things consumers buy. The Personal Consumption Expenditures index, or PCE, measures things people consume, including things they do not pay for directly, such as health care, which insurance and government benefits help to cover.

High inflation can be the result of a hot economy — one in which people have a lot of surplus cash or are accessing a lot of credit and want to spend. If consumers are buying goods and services eagerly enough, businesses may raise prices because they lack adequate supply or because they realize they can raise prices and improve their profits without losing customers.

But inflation can — and often does — rise and fall based on developments that have little to do with economic conditions. The Ukraine crisis may limit the supply of oil, making gas more expensive. Supply chain problems can keep goods in short supply, pushing up prices.

The inflationary burst the United States has experienced this year has been driven by both of these processes. The coronavirus has caused factories to shut down and has clogged shipping routes, limiting the supply of goods and pushing prices higher. But it is also the case that consumers, who collectively built-up big savings thanks to months in lockdown and repeated government stimulus checks, are spending robustly and their demand is driving part of inflation. 

Is Inflation Always Bad?

If your salary increases along with inflation, nothing has really changed: you can still afford exactly the same goods and services.  Recent jobs data show that average hourly earnings have climbed rapidly — and much more than economists expected – though not enough to keep up with rapid inflation.

If you’re retired and living off of your savings, inflation can bite. While the value of assets, like houses or stocks, can increase along with inflation, those on a fixed income will see their purchasing power decline.

If you are a borrower with an existing fixed-rate loan, inflation actually helps you. Inflation causes the price of goods to increase, but the cost of your fixed-rate loan remains the same. If you receive a raise, it takes a smaller part of your paycheck to repay the loan.

To summarize, inflation is good for borrowers, potentially neutral for investors, and bad for people who rely on a fixed income that does not keep pace with inflation.  

How Can Inflation Be Tempered?

In the U.S., the Federal Reserve generally controls the rate of inflation by raising or lowering interest rates. When inflation rises, the Federal Reserve raises interest rates in order to slow borrowing and, thus, spending. Reduced spending lowers demand for goods and services, reducing inflation.

Companies also respond to inflation in ways that bring prices down; they increase production.

What Is Happening Now?

The response to COVID-19 created an unprecedented situation.

• Many businesses, factories and shipping ports reduced output or closed entirely, reducing the supply of goods and services.
• At the same time, federal stimulus payments to individuals and loans to businesses combined with low interest rates increased demand, fueling inflation.

Businesses and policymakers are beginning to address the causes of inflation. The Federal Reserve is ending programs that supported the economy during the pandemic and initiating programs, such as raising interest rates, designed to combat inflation. In addition, supply chains are beginning to untangle. And, while it may take several years, companies are making big new investments to increase production and the supply of goods.

Inflation may not come down immediately – we can’t predict the pandemic’s future and it’s difficult to turn around a $23 trillion economy like ours – but the policies are in place to address the problem.

What Can You Do?

While it is difficult to mitigate the short-term effects of inflation, experts do offer suggestions on how you can reduce the impact on your household budget.

• Postpone big-ticket purchases, especially on items that have increased in price quickly, such as cars, where prices are likely to decline once supply shortages resolve.
• Establish and review your budget to ensure you are accounting for price changes over time.
• Build an emergency fund so you have cash available when temporary price fluctuations push you over budget or an unexpected expense arises.
• There is no silver bullet for protecting investment portfolios against inflation. Inflation is a long-term threat that cannot be fully addressed with short-term tools. For long-term investors, the single best way to combat inflation is to seek to outgrow it via a diversified portfolio that is in line with your goals and risk tolerance (see sample portfolios).

Conclusion

Inflation has been around forever, ebbing and flowing as the economy adjusts to changes in supply and demand. Our current pandemic-related inflation is unique in its causes, but the economic impacts fit the standard playbook. Federal policymakers are taking action designed to prevent inflation from worsening.

Living through a period of inflation causes anxiety. As a diversified, long-term investor, the JRB urges you to trust your financial plan. Prices will fluctuate and the world’s economy will adjust in the coming years. If you have questions about your asset allocation or ability to achieve financial security, please call us at 888-JRB-FREE (572-3733) for a complimentary financial consultation.

February 2022