How Concerned Should I Be about Rising Inflation?

Inflation has been a frequent topic in the financial press over the past year, especially in the past two months as annual inflation rates surpassed 7 percent.  In February, the increase in the Consumer Price Index over the previous 12 months hit 7.9 percent, reaching inflation levels that the U.S. has not witnessed since the 1980s.  Anyone who has attempted to buy a car or a house in the past year is very aware of this trend, as are drivers stopping at the pump these days.  Consumers have likely begun to notice at grocery stores and restaurants as well.  After decades of low inflation rates, many consumers are frustrated by and/or fearful of this recent change.  There are reasons to hope and expect that this bout of inflation will be neither as severe nor as persistent as inflation in the late 1970s and early 1980s, but it does underscore the need for an investment portfolio that protects your purchasing power over the long term.

Why Has Inflation Jumped over the Past Year?  Two of the main reasons for recent inflation are well known, while one may be slightly less apparent.  Obviously, the conflict in Ukraine and related sanctions against importing Russian oil have contributed significantly to the jump in gas prices over the past few weeks.  While gas prices had been rising steadily from late 2020 through early 2022, they surged nearly 25 percent over the past month.  This trend, of course, will increase the transportation costs and therefore the prices of other consumer goods in the short term as well. 

Prior to the Ukraine invasion, the price of many goods had been on the rise due to issues stemming from the Covid pandemic.  Labor shortages related to the pandemic (and pandemic-related government stimulus) caused the supply of many goods or component parts to decrease.  At the same time, a surge in spending on consumer goods (since it became difficult to spend money on services, travel, and entertainment) caused demand to increase.  As any Economics 101 graduate could tell you:  Decreased Supply + Increased Demand = Higher Prices.

Another more subtle contributor to inflation also relates to the government’s response to the pandemic.  Starting in April 2020, the federal government infused money into the economy multiple times with its stimulus packages.  The federal reserve also dropped interest rates around the same time, leading to an increase in borrowing, which also increases the money supply.  Even as the economy recovered from the initial shock of the pandemic in late 2020 and 2021, the government continued to pump money into the economy with stimulus payments and low interest rates. 

Will It Continue?  Given that the above issues related to Ukraine and the pandemic are not yet resolved, most financial analysts agree that inflation rates will remain relatively high over the short term.  However, the federal reserve is expected to finally start raising interest rates in a meaningful way this year, which should help stem the tide to some extent by tightening up the money supply.  Also, companies certainly have incentive to find alternatives to any goods or parts facing significant supply chain issues or those impacted by Russian sanctions.  Because certain industries and regions of the global economy have been disproportionately impacted by Covid and entanglement with Russia, there is reason to hope that inflation may subside as companies find alternatives to those affected areas.

Should I Be Concerned?  If you are still working, you may obtain a pay raise that will keep pace with inflation—or, at least, with the amount of inflation that you actually face.  Remember that not all of your monthly expenses are subject to inflation—e.g., if you own your home, the principal and interest portion of your mortgage payment will not increase, regardless of inflation levels.  If your salary or other income does not increase this year, you may face tighter monthly cash flow.  If you can adjust your spending accordingly though, this will have benefits in terms of long-term financial planning by lowering the standard of living that you need to support in retirement.

If you are retired, some of your retirement income may keep pace with inflation through cost-of-living adjustments.  Federal government pensions and Social Security benefits, for example, received generous cost-of-living adjustments moving into 2022, with a pay raise of 5.9 percent or 4.9 percent for federal government retirees (depending on their pension system) and 5.9 percent for those receiving Social Security benefits.  Unfortunately, most private company pensions do not have cost of living increases.

Retirees whose investment portfolios have a sufficient allocation to growth assets likely experienced investment returns in the same range as (or higher than) the inflation rate over the past 12 months as well, depending on their investments and their allocation between stocks and bonds.  The S&P 500, for example, jumped over 16 percent in the 12-month period ending in late February.  Some other segments of the U.S. stock market performed even better.  Returns for bond funds were paltry, as might be expected given the interest rate environment, but that just underscores why it is important for most investors to maintain exposure to the stock market in their portfolio even through retirement.  In general, long-term inflation rates in the U.S. have averaged less than 4 percent per year (even if you include the crazy 1970s and early 1980s), whereas investment returns for a balanced portfolio (i.e. 60 percent stock funds, 40 percent bond funds) have averaged over 8 percent.  Therefore, as long as you have investments and a portfolio allocation that are well-poised to capture that long-term growth, you need not fear inflation in retirement.

If you have questions about how inflation might impact your particular financial situation and would like to discuss further, please feel free to call or email us any time.