What Is Inflation?
By Ryan Glinn
W3 Wealth Management
According to our dear friends at Merriam-Webster, economic inflation is defined as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.”
To be a bit more concise, inflation is simply the steady increase in price of goods and services in an economy over time.
Inflation can be caused by a variety of factors. However, it most commonly occurs when demand is greater than supply. When demand exceeds supply, prices will rise until supply can match demand. Excess demand typically occurs when the economy is in overdrive, which is signified by low unemployment combined with high levels of investment and consumer spending. A tight labor market can stress the ability for companies to increase their outputs enough to meet demand. These forces together can push inflation higher.
Inflation can also occur when the money supply outpaces economic growth, as more dollars chase the same amount of goods. Additionally, supply side or cost-push inflation can persist when production costs increase, driving down supply.
Inflation is measured by the Consumer Price Index. The CPI is a measure of the average price increases of goods and services in the economy year over year. It includes food, utility and energy prices, among others. This gauge typically focuses on price trends in urban areas, which make up 80% to 90% of the population in the United States. From 2019 to 2020, prices rose 1.4%.
Is Inflation Bad?
Believe it or not, a controlled level of inflation is viewed positively. Consistent price growth over time shows that the economy is growing. This growth is displayed through continued demand, which in turn leads to increased prices and the hiring of new workers to ramp up supply. This explains why the Federal Reserve has set its inflation target at 2%.
However, high levels of inflation can be detrimental to the economy. Too much demand can lead to price hikes, squeezing the average worker’s purchasing power when wage growth cannot keep up. Furthermore, if you combine this increased demand with an increase in the money supply, hyperinflation can occur. This is when monthly inflation exceeds 50%.
Remember Germany’s Weimar Republic in the early 1920s? Already saddled with high debt levels resulting from war-time financing, the government decided to print money to pay the salaries of striking workers. In 1923, the inflation rate was 322% per month. Venezuela and Zimbabwe are more recent examples of hyperinflation.
On the other hand, you could also see inflationary pressures combined with high unemployment and a weak economy. This is referred to as stagflation. The most common example of this is the United States in the 1970s. Coming off expansionary monetary policy that had increased the money supply, the United States ran into the OPEC oil embargo. The rise in oil prices did not just hurt people at the pump. It hurt many industries and ultimately sent the United States into a recession. This oil price shock is an example of supply-side or cost-push inflation.
How Does Inflation Affect Me?
Inflation impacts your purchasing power over time. A dollar today does not equal a dollar tomorrow when there’s inflation. A gallon of milk in 1960 cost 49 cents. Gasoline was 31 cents per gallon. This is especially important to consider when saving money and planning for retirement. My grandfather told me his biggest shock during retirement wasn’t the Dot Com bubble bursting or stock market rout in 2008, but how impactful inflation had become since he retired in the early 1990s. From 1990 through 2018 the average inflation rate was 2.36%.
Bank accounts often cannot keep up with inflation, which is one reason why many Americans invest in the stock market. A sound financial plan should account for inflation.
Retirement planning software such as E-Money, MoneyGuide Pro and Right Capital all have inflation assumptions around the 3% range. This is roughly the historical average of inflation in the United States. These software programs assume that you’ll raise your spending each year by roughly 3% to offset the cost of living increase typically caused by inflation. Similar projections can be forecast using Microsoft Excel. The point is that inflation should be accounted for in some manner because it has been a constant throughout our history.
Let us consider a retiree who has a $30,000 per year Social Security benefit. That $30,000 per year benefit with no cost of living adjustment pays out $750,000 over 25 years. Adding an annual 2% cost of living adjustment over that same 25-year period would increase total benefits paid to $960,908.99. That is more than a $210,000 difference – roughly $8,400 per year!
Consideration to Help Protect Yourself Against Inflation
Inflation can be hedged in a variety of ways. We just mentioned the stock market. Owning stocks has proven to counter inflation over the long run. Certain types of stocks may weather spikes in inflation better than others. For example, companies that have pricing power in their industry can increase prices to offset inflation’s impact. Food and beverage companies within the consumer staples sector are good examples. Utility companies also provide defense against rising prices. You have to eat and pay your electric bill, right? The commodities sector is another area that traditionally acts as a buffer during inflationary times. Companies that operate in oil and gas, timber or precious metals fit the bill here.
A hot topic of late is the rise of cryptocurrencies, such as Bitcoin. Some investors view these alternative currencies as a hedge against the U.S. dollar and inflationary pressures. However, cryptocurrencies are a relatively new phenomenon and extremely volatile.
Bonds are typically not the best inflation hedge. Interest rates tend to rise in inflationary environments. When interest rates rise, bond prices fall. However, Treasury Inflation Protected Securities are a type of Treasury bond designed to combat inflation. In fact, their principal is linked directly to the CPI.
Finally, real estate can be an effective tool to combat inflation. Rental property rates can be increased to reflect overall price changes in the economy. This can hold true in commercial real estate as well. Having exposure to real estate investment trusts within a portfolio is a way to participate in real estate without physically owning the properties.
Where Inflation Is Today
Some analysts are suggesting the pent-up demand because of the stay-at-home nature of the pandemic combined with massive government stimulus will lead to inflationary pressures. Most economists predict demand spikes around the back end of this year and in 2022 as more people are vaccinated.
While inflationary pressure is likely to follow any increase in demand, there are counterpoints to the notion that inflation is out of control. First of all, there’s still a tremendous amount of slack in the labor markets. In February, the Congressional Budget Office predicted the number of people employed will not reach pre-pandemic levels until 2024. Additionally, should inflation pick up, the Federal Reserve could tighten monetary policy and raise interest rates. There’s little doubt that significant inflationary pressures would put significant pressure on the Fed to control it.
The information provided does not constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. The example(s) given are hypothetical and are for illustrative purposes. Actual results may vary from those illustrated Fee-Based Planning offered through W3 Wealth Advisors LLC, a state registered investment adviser. Third party money management offered through Valmark Advisers Inc. a SEC Registered Investment Advisor. Securities offered through Valmark Securities. W3 Wealth Management, LLC and W3 Wealth Advisors LLC are separate entities from Valmark Securities, Inc. and Valmark Advisers Inc.
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