After years out of the limelight, inflation has roared back into the headlines, with percentage increases not seen in 40 years. Inflation affects you in many ways, so it makes sense to understand how it works and what you can do about it.
Inflation causes you to lose purchasing power over time. It is a general rise in prices that reduces how much a dollar will buy. In the US, we measure inflation as the annual price change for a basket of goods and services. The Consumer Price Index (CPI) applies to urban consumers, whereas the Personal Consumption Expenditures index (PCI) measures items that people consume, including things not paid for directly (such as health care).
The Federal Reserve is in charge of controlling inflation, which usually means limiting PCI increases to no more than 2%. Modest inflation is generally good for an otherwise healthy economy, but higher levels erode your ability to buy the things you need and want. High inflation can result from supply shortages or a surplus of cash or credit in the economy.
When consumers have more money to spend, they compete for available goods and services. Inflation is, in effect, the rationing of purchasable items through price increases. Unusual events, like the Covid-19 pandemic, can also spur inflation.
Inflationary price bursts may fade as quickly as they appear, but they can linger for extended periods. One theory states that inflation will continue if workers demand and get compensating wage increases. Employers pass the higher wage costs onto their customers, fueling the inflationary cycle.
Hyperinflation is ruinous, and high inflation is destabilizing. But the effect of moderate inflation is a hotly debated topic. Here are some ways you might feel inflation’s impact:
Investments in fixed income securities typically lose value during inflationary times. The reason is that new bonds will pay more interest than old bonds to attract investors. The prices of seasoned bonds decline, leaving with a paper loss. If you don’t sell your bonds, you can redeem them for their face value upon maturity, but until then, you will be collecting less interest than you would from new bonds.
Variable-rate debt, inflation-adjusted bonds, and cash can benefit from higher inflation.
If you think inflation will be around for some time to come, you might want to accelerate any big-ticket spending you’ve been anticipating because it will only become more expensive if you wait.
Stocks are a good inflation hedge, which might motivate you to reallocate some of your other assets to equities. You might also consider convertible bonds and warrants as a surrogate for stocks, as they supposedly provide upside performance with less downside risk (although this is not always the case). Treasury Inflation-Protected Securities (TIPS) and US Savings I-Bonds compensate you for higher inflation, but TIPS are often overpriced. Cash in an insured account is a safe bet, but don’t expect much return on an inflation-adjusted basis. If you are aggressive, you might consider investing in real estate directly or through real estate investment trusts (REITs).
In sum, inflation can be a challenge and an opportunity. Consulting with a financial advisor can help you navigate these tricky times.