Many of us dusted off our thicker winter jackets recently. Did you find a dollar bill tucked away in a coat pocket? Maybe it doesn’t happen as often as it used to – since most payments are digital these days – but it’s always nice to find forgotten cash.
Say you discovered a few bucks that had been stashed away for a year or longer. Those dollars would buy less today than they would have. This is a well-known, dreaded reality: inflation erodes the value of our money.
Last year, inflation became a key topic in the financial planning profession and in daily life. It’s for good reason. After decades of below-average inflation, it spiked above its long-term average of 2.9%.
A Coat Pocket Find
My wife, Amanda, visited her grandmother in Indiana in November. Grandma Jones still has an assortment of clothing from the 1980s and 1990s. Now they’re in vogue again! Amanda was grateful when Grandma let her pick a few items to have.
Amanda didn’t find any hidden cash. Instead, she found in one of Grandma’s coat pockets a grocery store receipt from December 22, 1990. Grandma apparently needed a few things from Pay Less (a Kroger store) to round out the pantry for Christmas.
Inflation feels more real when we can relate to it personally. Holding this old receipt made it feel personal to Amanda. Let’s compare the price Grandma paid in December 1990 to December 2021:
What about non-grocery expenditures? Over the same period of time, the MSRP on a new Honda Civic EX sedan increased at a 2.7% annualized rate, the average movie theater ticket price rose at a 2.6% annualized rate, and we experienced a 2.5% annualized rate of inflation broadly (measured by the Consumer Price Index).
The Recent Spike in Inflation
November 2021 data showed that the U.S. Consumer Price Index rose at a 6.8% pace relative to November 2020, the fastest rate since 1982. That was the sixth month in a row with gains over 5%. What’s more, inflationary pressures seem to be broadening out and accelerating in some areas. The Federal Reserve (Fed) Chairman Jerome Powell stopped using the infamous “transitory” adjective on November 30, 2021.
Mohamed El-Erian, Allianz Chief Economic Advisor, explains an aggravating feedback loop, “We have ample evidence that there are behavioral changes going on…. Supply disruptions are lasting for a lot longer than anybody anticipated. Consumers are advancing purchases in order to avoid problems down the road – that of course puts pressure on inflation.”
In a 2021 Student of the Market presentation, BlackRock points to four potential reasons inflation is rising. Firstly, it may be a function of monetary policy. The Fed maintains a 2% inflation target when considering policy changes, but it’s not a hard-and-fast target. The Fed has indicated it will let inflation drift above 2% following periods where it has been below.
Second is fiscal policy. The fiscal stimulus provided in the wake of the COVID-19 recession was unprecedented. The total fiscal stimulus done by mid-2021 was about double the pandemic-inflicted loss in gross domestic product. It was close to 25% of 2020 GDP.
A third reason is pent-up demand. Consumers, either by choice or necessity, lowered their spending in 2020 in light of the recession and restrictions. The personal savings rate jumped from a low of 8% pre-pandemic to 20.5% in January 2021. As 2021 elapsed, American consumers felt more willing and able to spend, causing inflationary pressures on the demand side.
A fourth reason, rising production costs, amplified the pressures from the supply side. Supply chain disruptions meant that production and transportation costs on most tangible goods increased. Consumers bore the brunt of those increases, which we saw at the pump, in the checkout lane, and elsewhere.
Now the Fed thinks wage and price pressures might become entrenched. The Wall Street Journal reported on November 30, 2021, “Federal Reserve Chairman Jerome Powell said the central bank was prepared to quicken the pullback of its easy-money policies, opening the door to raising interest rates in the first half of  as it grapples with inflation and a potential new virus wave that could exacerbate supply-chain disruptions.”
What It Implies
We believe we should assume above-average inflation will continue for a year or two before returning to the long-term average. We feel inflation should be underscored now more than it already was in financial planning and investment management conversations. This may affect different peoples’ financial plans differently.
The real rate of return is an important concept. It’s the rate of return on your savings or investments after inflation. It indicates whether your account is gaining or losing purchasing power. Keeping cash set aside for emergency and short-term spending needs contributes to peace of mind and financial success. However, having excess cash balances can be detrimental to long-term financial goals.
Investing excess cash in a well-diversified portfolio is crucial to keeping up with price increases over time. Stocks are an asset class known for combating inflation. According to Morningstar, since 1990 the S&P 500 stock index has returned 8.9% during years when inflation has been above 3%. Some other broad asset classes that have a reputation of holding up to inflation are real estate and commodities.
The performance of different types of bonds varies a lot during inflationary cycles and rising interest rate periods (which generally accompany or follow high inflation). Long-term bonds, for example, suffer in those conditions. During such times, it could make sense to keep bond investments short in duration, to consider inflation-protected bonds, and/or to consider floating-rate securities among other things.
Like always, your strategy should remain centered on your goals, risk tolerance, and investment time horizon. Your financial advisor would be glad to review them with you. Inflation is real to all of us, whether you found proof of it in a coat pocket or somewhere else.