“When you are paying more for bread and butter, it’s hard to remember that inflation can have both negative and positive effects on an economy.”-Robert Layman
Inflation has a well-deserved bad reputation. It is, after all, a direct cut to your paycheck because your money buys fewer goods and services necessary to maintain your lifestyle. Any increases to your wages tend to get eaten up, sometimes leaving you worse off than you were before you got a raise. In addition, inflation tends to beat up on the frugal, punishing responsible people who plan for the future or attempt to create an emergency fund. The actual value of your retirement accounts is eroded because it takes more of your money to purchase the same goods and services.
Inflation sometimes has positive effects.
Many economists say that mild (1-2%) inflation is suitable for an economy. One of the side effects of mild inflation is that people tend to spend sooner rather than later because they realize prices might be much higher in the future. This spending drives growth and creates a more dynamic economy. The Federal Reserve has set an inflation target for the United States of 2%.
Investing is also spurred when people believe that inflation is on the rise. Since equities can often be effective hedges against inflation, investors tend to flock to the stock market. Even more volatile assets such as precious metals can help insulate against price increases.
As inflation increases, you will often see capital improvements made in the business world, such as parking lot repairs, roofing, additions, and new construction. This is because business owners know that costs for such improvements are likely to increase during an inflationary period.
Inflation does not impact all assets the same.
One of the difficulties in structuring a portfolio to withstand inflation is that inflation does not affect everything the same way. For example, home prices could fall while fuel prices double. Demand for certain “luxury” items could drop, causing prices to go down significantly, while staples such as bread, milk, and heating oil rise. When finding yourself in an inflationary cycle, it’s crucial to sit down with your advisory team to ensure that you balance the effects of inflation on your portfolio. You might also want to re-evaluate the mutual funds in your 401k, IRA, or other qualified plans to ensure you don’t have too much exposure to inflation-sensitive assets.
When inflation causes MORE inflation, it’s a vicious circle.
Unfortunately, Americans’ reaction to spending and investing when faced with inflation can contribute to a boost in inflation. This situation can quickly turn into a catastrophic feedback loop. Frightened by the specter of high inflation, people and businesses spend more cash quickly as they try to offload their depreciating currency. These actions, in turn, increase the money supply so that the economy becomes saturated with cash no one wants. The money supply outstrips demand, causing the purchasing power of currency to degrade even faster. Businesses and households sensing an inflationary crisis typically stay fully-stocked instead of holding onto cash. This loss of confidence in the currency then leads to hoarding and empty shelves. Every paycheck received during an inflationary period could turn into wild spending sprees by people desperate to offload their cash.
Inflation is complex and stealthy
The causes of inflation are complicated, involving a mixture of human nature and bad monetary policy. Inflation certainly rewards spenders, especially national and state governments, who pour trillions into the economy through stimulus plans. Much of the inflation we have today is a direct result of such monetary policies. Government-created inflation may be thought of as a hidden form of taxation, eroding wealth at a brisk pace and allowing politicians to fund their projects without raising tax rates.
The Big Picture
Volumes exist that tackle the subject of inflation and its’ effects on American wealth. Yet, inflation remains a complicated, controversial subject and one of the most significant destroyers of wealth. Pre-retirees who want to blunt some of inflation’s adverse effects must be sure to partner with an advisor to balance their assets accordingly.