Inflation hasn’t been a topic of discussion for a while, other than perhaps…” where did inflation go?” Sure, we heard about a desired inflation rate when the Fed spoke, but the desired rate of 2% seemed unobtainable. And then, after years of subdued inflation, markets reacted to the threat of increasing inflation. As the market considers the impact of inflation, I think it worthwhile to review what causes inflation and more importantly, how inflation impacts your financial plan.
What is Inflation?
If I ask people to define inflation, I think most would refer to it as…the rise of prices over time. The easiest example is being reminded what our parents paid for their homes. “Imagine buying that house for XX dollars?”
As I searched online, I came across Investopedia’s definition. When discussing the inflation rate, Investopedia begins “A measure of how fast a currency loses its value. That is, the inflation rate measures how fast prices for goods and services rise over time, or how much less one unit of currency buys now compared to one unit of currency at a given time in the past.”
I don’t think most people would use the words “loses its value” when considering inflation. When considering future funding of financial goals, this is the phrase we should consider. A good (or bad depending on perspective) example is the impact of inflation on guaranteed income (pensions).
Inflation risk for guaranteed income
I often hear “I wish I had a pension.” This “wish” is based on the desire to remove “risk.” In this case, the person is usually referring to the risk of market losses. Sure, a pension payment removes market risk…you receive the same check (assume no inflation adjustment) every month no matter what the market does. This provides mental security as you know what is coming. It feels comfortable. It feels like a paycheck. We know what to do with a paycheck.
The removal of market risk creates exposure to another form of risk and the real benefit of a pension (or fixed annuity) isn’t the removal of market risk (my opinion). The real benefit of shifting assets to a pension (or fixed annuity) is the hedge against longevity.
A pension payment is guaranteed for your lifetime (or multiple lives depending on your choice). You know you will receive “the check” every month (or however paid). Most pensions are not adjusted for inflation. In other words, the payment you receive in the first month is the same as your last month. But, what happens if prices increase? Or as Investopedia states…you “lose value?”
Because the payment remains constant, in a period of rising inflation, the guaranteed check loses value in real terms. Consider someone (or couple) who has a living expense of $50,000 with a $35,000 annual pension. Today, the pension funds 70% of their living expense goal. With a 2.5% inflation (assuming pension is not inflation adjusted which is the case for most), that same payment covers 59% of the living expense in ten years. The payment hasn’t changed. The cost of goods increased by 2.5% each year. Imagine the impact if we considered of 20 or 30 years.
Next, consider a scenario with 5% inflation. The pension still covers 70% of the desired living expense today. But, that same living expense increases to $70,000 with the 5% inflation rate (ten years). The pension payment now funds 50% of the desired living expense. Keep in mind, the historical inflation rate is around 3-4% depending on what period is being measured, with significant outliers (both high and low).
The example is not meant to diminish the benefit of having a pension or a fixed payment. Instead, the example reveals the cost of inflation and shares how removing one risk opens exposure to another. In the end, the more tools available in your plan the better.
What causes inflation to rise?
The simplest answer…supply and demand. More importantly, expectations (short run) and the impact (long run) of adjustments to various factors. When predicting outcomes, we keep all other factors constant. This allows us to focus on the specific adjustment. Although assuming all other factors remain constant is naïve, we must start somewhere.
In theory, when the government “prints” more money, the supply of money grows. When considering “printing” think about the government making more money available (either through cheaper rates, buying bonds or other tools) rather than running down to the basement and firing up the printing press.
With more money in circulation, people “should” spend more. If people are buying more goods and services, the demand for that same set of goods increases. This raises prices until demand equals supply. In the end, the real value hasn’t changed. You have an extra dollar to spend, but the same set of goods and services cost a dollar more. Let’s consider the other side of the equation.
Consider a scenario where demand for a resource increases. The resource could be something like housing. If the demand for housing rises and the supply remains unchanged, sellers will raise prices to maximize profit. When this happens, new sellers are likely to add their houses to the market (increasing supply) or buyers find housing too expensive and demand drops.
Let’s consider employment, which is the recent focus on the demand side. As unemployment rates drop, theory says there is a lesser supply of qualified applicants for new (and existing) positions. With a smaller supply, employers need to increase wages to “incentivize” qualified applicants. The additional wages are good for employees (short term), but as people have more income, they spend more (theory) which increases demand. As you may have guessed…higher demand with no change in supply equals inflation and when considering real purchasing power, consumers are no better off.
Why does inflation matter to the markets?
If inflation rises faster than the Fed would like, they will likely raise rates. As the risk of inflation rose in early February, the fear of additional rate hikes increased. The question of how fast the Fed will raise rates became a topic again. Higher interest rates create a higher cost of borrowing. Higher rates tend to slow the growth of the economy unless people are compensated for the rising prices. The real question…can we have growth without inflation? This is where the debate gets interesting and will be saved for a future post.
Shouldn’t low borrowing costs cause inflation?
This has been a frequent topic of discussion when reviewing Fed notes since 2008. The goal of taking interest rates to zero was to induce investment and spur growth. When borrowing costs are low, your barrier to earning a profit is low (just beat the borrowing cost). Many of us have had this conversation when discussing mortgages. But, to the Fed’s surprise, low interest rates didn’t create inflation, nor did they provide the expected growth. Why?
A recent conversation with a client reminded me of what was missing. The missing piece has been wages. More specifically, the lack of growth for most wage earners. The cheap money resulted in company stock buybacks which benefited shareholders, rather than increase jobs and wage growth. So, while the markets kept going higher and corporate profits increased, wages remained stagnant. With no additional money to spend, employees didn’t increase demand. Therefore, no inflation. But, that may be changing.
Earlier, I shared the demand example when considering employment. Depending on who you ask and which measurement you use, we might conclude the U.S. is getting closer to full employment. This will be important when considering future inflation threats. As the U.S. gets closer to full employment, companies need to raise pay to attract desired help (as mentioned above). Will this create a rise in wages? Only time will tell.
Inflation threatens retirees and those close to retirement more than those remaining in the workforce. We already discussed the scenario of someone retiring with a pension. Even those who do not have a pension are threatened by increasing inflation. This is due to the stoppage of employment income.
While in the workforce, at least some of the inflation risk is offset by rising income (or so we hope). As you enter retirement, we consider how your plan will be affected by inflation. Here are a few considerations.
Pension. As we return to the pension scenario, we recognize the current payment will cover a greater amount of expenses than later in life. The pension is treated as fixed income which allows us to be more aggressive elsewhere because we need fewer dollars today (pension covers a higher percentage). This allows us to position the portfolio to benefit from increasing inflation.
Social Security. This is a guaranteed income source that is adjusted for inflation. We often consider delaying receipt of payments and almost never (never say never) recommend taking benefits earlier than full age. By delaying the payment, you are not only receiving a higher payment, but that higher payment is adjusted for inflation.
Investments. When considering investments, we focus on “real” returns rather than nominal. When focusing on real returns, we assume a level of inflation and focus on the return above the inflation level. We assume your expenses will be greater in the future. Our goal is to create a plan where the growth offsets the increase in costs. We focus on real results rather than nominal returns.
We could go deeper into this topic and we may in the future. For now, when you hear about inflation (and you will), remember…we’ve already considered it. There will be surprises in the short term, but your plan is for the long run.
If you have questions about how your portfolio and more importantly, your plan addresses the threat of inflation, please let me know.Photo by Vladimir Solomyani on Unsplash