Is Inflation Haunting Your Financial Dreams?

You’ve probably noticed that prices — on food, lumber, furniture, cars, and whole host of other items — have been ratcheting upward lately. Is the situation temporary as the U.S. economy recovers from the effects of COVID-19, or something more persistent and long-term?

 Last Wednesday, the Federal Reserve expressed optimism over the economy’s progress, announcing that while it will leave interest rates at their current low levels for now, it’s projecting possible interest rate hikes in 2023, a year sooner than it previously anticipated. In a statement, the Fed said indicators of economic activity and employment have strengthened, but inflation, which has risen recently, reflects “transitory factors.” But things continue to change. The Fed now expects inflation to reach 3.4 percent this year, higher than its previous forecasts. In March, for example the projection stood at 2.4 percent.

What Is Inflation?

Inflation is the rate at which a currency loses its purchasing power as prices increase over time. So, say a cup of coffee cost $1.00 twenty years ago. If the average annual inflation rate had been 2% between then and now, that same pour would now cost you $1.49. Various goods, services, and sectors often experience different rates of inflation at different times, but general inflation is usually calculated based on the Consumer Price Index (CPI), or a similar broad pricing index.

Recent headlines have been reporting a noticeable uptick in inflation. Superlatives like “best” and “worst” grab the most attention, so outlets have been abuzz with reports of how a 5% May consumer pricing surge was “the biggest 12-month inflation spike since 2008.”

Putting Inflation in Proper Context

Before you read too much into these recently rising numbers, it’s worth remembering their context. We’re comparing May 2021 to May 2020, when we were still deep into what The Wall Street Journal called a “screwy” pandemic economy. The WSJ explained, “If a company takes a hit in one year and then gets back to normal the next, it can look like its profits are soaring when in fact they are just getting back on track.”

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Zooming out even further, the Federal Reserve’s 10 Year Break-Even Inflation Rate is one common estimate of the market’s expected average annual inflation rate for the next 10 years. As of mid-June, that rate stood at 2.3%. That’s up from the lower 1.2% rate expectation from mid-June 2020, but it’s still not eye-popping.

Which leads to another important point: Not all inflation is bad. In fact, a bit of inflation goes hand in hand with economic growth and reasonable interest rates for lenders and borrowers alike. A 2% annual inflation rate is typically considered a desirable norm for greasing the wheels of commerce, without destroying the working relationship between currencies and costs. As inflation rates creep upward, the Federal Open Markets Committee (FOMC) can implement monetary policy to help course correct the economy.

What if Inflation Runs Amok?

And yet, while inflation has its purposes, it’s concerning if it goes on a rampage. When it does, uncertainty has spiked as well, wreaking havoc on commerce, the economy, job markets, real estate, and financial markets. (Deflation—the opposite of inflation—can also upset the economy if prices drop too precipitously.)

Investors who were around in the 1970s may remember the last time the U.S. experienced red-hot inflation, and what it felt like when it spiked to a feverish 14.8% in 1980.

The New York Times described it as an era when “prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 percent, and interest rates on bank certificates of deposit approached 12 percent. It was hard to know whether a 5 percent pay raise was cause for celebration or despair.” While 12% CD rates may sound great, when interest and inflation rates are comparable, the real returns from even high-interest CDs essentially become a wash.

After the 1980 high-water mark, the Volcker-era Federal Reserve tamped inflation back down. So younger investors have heard of, but never experienced such steep inflation for such an extended time. Despite occasional alarm bells, inflation has mostly continued to hit the snooze button for decades. At least so far.   

While there’s no way to predict inflation, historical data shows that both increases and decreases in inflation can be persistent. In Inflation: An Exchange Between Eugene Fama and David Booth, Nobel laureate Fama says persistence is a characteristic of inflation, and that because we haven’t seen high or even moderate inflation in at least 10 years, he isn’t concerned that it will be high anytime soon.

Control What You Can Control

What if inflation does get out of hand, and stays that way for a while? How can you protect your assets? A recent Wall Street Journal article weighed the pros and cons of five different approaches, and concluded what many smart investors already know ­­— there’s no perfect portfolio that wins big, whether inflation appears or not.

As David Booth and Eugene Fama discuss, it’s best to take a long-term view of the markets, understanding that there will be ups and downs. If you are a client of AMDG Financial, we’ve worked with you already to choose an investment strategy that reflects your tolerance for risk. If inflation does increase and persist, the next thing to control is your emotion. Remember, reacting to a crisis by leaving the market is just another form of market timing. We can’t control what the markets will do, but we believe they incorporate all available information. That means, by the time investors learn about an event, prices have already adjusted.

We also know that moving in and out of the market can actually cost you money and could have potential tax implications. On top of that stress, you may experience anxiety around deciding when to get out and when to get back in.

No matter what happens to cause fluctuation in the markets, we believe that an investment strategy that reflects your goals, includes proper diversification, and prioritizes prudent investment management is the best way to prepare for negative market events. We’re here to help you stay on track, so if you have questions or concerns, please feel free to contact us anytime.


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