The silent killer of many financial plans is the gradual increase of the price of goods and services over time, otherwise known as inflation. This mysterious villain is often neglected because these price increases are so gradual, they are hardly noticed day by day, until you reflect on what things used to cost 10, 20, or 30+ years ago. This has been especially true over the past decade when inflation has been so much less than in the past.
Although inflation has been quiet up until recently, it is hard not to notice it when paying more at the pump, buying (or attempting to even find!) some lumber for a home improvement project, or just seeing inflation mentioned more in the news. Is inflation here to stay? Is this just a temporary increase? How does this impact your portfolio? These are a few of the many questions we have been hearing about the current economic environment.
Is Inflation Bad?
Although I may have unfairly maligned inflation in the paragraph above, it is not necessarily bad. Like many things in life, inflation is subject to a Goldilocks interpretation. You do not want it to be too high, too low (or negative), but just right.
When inflation is too high, and uncontrolled, you can get into a situation where prices spiral out of control and keep climbing higher. If inflation is too low, especially negative, this causes a deflationary environment. If prices keep decreasing it encourages consumers to defer spending to try and purchase at a lower price. As prices continue to fall, this only incentivizes continued deferral which can cause economies to stall. But when you have a little inflation, it keeps deflation, which you do not want, at bay. However, prices are not increasing to the point where they become unsustainable. In fact, the Federal Reserve has maintained an inflation target of around 2% for this very reason.
How is Inflation Measured?
In the US inflation is typically measured by a metric called the Consumer Price Index (CPI). The CPI index is similar to a mutual fund in the sense that it tracks a diversified "basket" of goods and services, somewhat as a mutual fund will invest in a variety of stocks. Some of the prices of goods will go up, others will go down, but the CPI tracks the aggregate of these increases.
Of course, these areas can be broken down more narrowly such as viewing only energy, building supplies, food, etc. But as an aggregate measure for inflation, because not all goods will increase at the same rate at the same time, CPI is the general benchmark to track overall inflation.
What's Happening With Inflation Right Now?
Watching the news today it may be hard to avoid the astonishing increases of certain goods, such as lumber and gasoline. These goods in particular have seen a meteoric increase in a relatively brief period of time. Lumber specifically has seen over a triple-digit increase compared to a year ago. Wasn't the Federal Reserve's target 2 percent?!
Like with most diversified indices, a significant increase, or decrease, in one item does not necessarily have an outsized impact on the entire index. While certain items have increased significantly compared to a year ago, overall inflation is much more modest at 4.2% as of the last reporting.
Although 4.2% is very different from 100% or more, it still begs the question of whether inflation has really returned. This can be especially concerning for savers when bank accounts are yielding far less than even 1%.
What is the Future for Inflation?
Just like with predicting the stock market, no one can perfectly predict what will happen with inflation. Just like with any contested subject, there are compelling arguments both for and against the prospect of sustained inflation.
By now it does not make sense to belabor the point that 2020 was far from a normal year. Businesses shut down, travel all but ceased, and people completely upended their daily routines and plans because of the pandemic. As vaccines have rolled out and people are becoming more comfortable returning to some semblance of "normal", many previously depressed industries are beginning to make a resurgence.
As economics 101 taught us, market prices are powered by supply and demand. During the peak of the pandemic certain industries, such as travel, experienced a plummet in demand. When this happens prices decrease, and in some cases significantly.
In some of these previously depressed industries we are beginning to see demand explode with supply either near the same amount, or even less than what they were previously. When this happens, the invisible hand of the market causes prices to increases until supply has a chance to catch up or demand subsides.
One camp, including the Federal Reserve, believes that this inflation is "transitory" and inflation will stabilize and return to more modest levels once the market has a chance to catch up, and the pent-up demand of consumers evens out over time. When you couple a decrease in prices at point A, and increases from pent up demand at point B, the measured percentage of inflation will look staggering, when this in fact, may only be temporary and does not truly reflect the full picture.
The other side of the argument is that inflation is not temporary and should be expected to increase even more quickly in the future. This rationale, briefly, is that the amount of money available to spend in the economy has increased substantially. When the supply of money is greater, the perceived "value" of each dollar is less. With more money available to spend, demand can outpace supply which pushes prices upward.
If we look at a chart of the amount of money available now compared to a year ago we can clearly see this increase. This argument is that we have only just begun to experience inflation, and as the economy continues to open, these extra dollars will be spent, and not saved. This in turn may continue to push the price of goods higher and may be sustained longer than a brief transitory period.
So, Who's Right?
If only we could predict the future and know. Both sides have compelling arguments, and we can see either scenario in our future. However, regardless of what happens with inflation, it is out of our control. We can only control what is inside our personal circle of influence and the Fed's monetary policy, inflation, and the price of lumber are all well out of our circle. We strongly believe in only focusing on things that you can control and let the rest of the chips fall where they may.
What Should You Do?
Inflation is always a risk for any financial plan. Although past performance cannot predict future results, staying invested in the stock market has been one of the best hedges against inflation over the long term. When raw material prices increase it costs more for companies to produce a product or service, reducing their profit margin. To account for this, they in turn increase the price of their goods, and pass that cost on to the consumer. This keeps their profit margin stable, even when inflation is present and the costs to create products increase. When an economy is functioning well, wages will also increase in turn so that consumers can continue to afford these goods even as prices rise. This is the circle of economic life.
In addition to the price companies charge increasing, the assets that they own also increase in value, improving their overall worth. When you buy a stock, you are acquiring ownership in that corporation. That means you own a fraction of everything the company owns. Most companies own something beyond the intellectual property of their founders, including real estate, equipment, and other tangible assets. When inflation is present, and the value of these assets increase, this also gets reflected in the companies’ stock price. This is another reason stocks are a traditional stalwart against inflation.
In summary, whether sustained inflation comes to fruition or not, one of the best courses of action you can take is to continue to stay invested in the stock market and continue investing when appropriate.
What About Cash?
Cash is an asset that is almost always eroding in value due to inflation. This is par for the course. However, cash plays a vital role in any complete financial plan. Cash set aside is necessary to provide a buffer against any unexpected expenses and reduce the risk that you will need to sell stocks in an emergency if they have (historically temporarily) decreased in value. We strongly advise our clients to maintain anywhere from 3-6 months' worth of expenses set aside because of this. This is irrespective of whether inflation may be on the horizon or not.
However, because we know that the purchasing power of cash will decrease over time, we also strongly advise not keeping too much parked away. You should have enough where you can be comfortable and sleep at night, but not so much where it is slowly being eaten away by the invisible force of inflation. If you find that you are accumulating, or already have, a significant amount of cash, and do not have any short-term needs for it, it may make sense to invest some of it in assets that historically have provided long-term growth that keeps up with or exceeds inflation. This is especially true in an environment where there is a risk of inflation rising quickly, which can rapidly reduce the amount of goods your cash can buy.
Often when people think of risk, they think of the value of their investments decreasing due to a drop in the stock market. A large hoard of cash carries its own risk of its purchasing power decreasing over time. Although this is often overlooked, this risk can be just as great, if not greater, to the overall success of your financial plan.
Inflation is the gradual rise of the cost of goods and services over time. Although we have seen some dramatic increases in certain assets in recent months, it is unclear whether this will be temporary or persist into the future. Since we cannot know this in advance, it is best to stay the course with your investments, but reevaluate your cash position to determine whether you have too much, or not enough, based on your needs. With inflation being the silent killer of many financial plans, it may make sense to work with a qualified financial planner to review your plan with you.
Nick Prigitano, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first. If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors.