Following a year of economic instability, it appears that many of us are turning our attention to something that’s been around for decades, but has recently piqued national interest – inflation. In fact, a recent study found that people are Googling the word “inflation” at a rapid rate, with a peak not seen since 2008. Check out this chart:
Since the start of the COVID-19 pandemic, six major stimulus bills totaling around $5.3 trillion have passed. With these efforts to alleviate pandemic-fueled financial strife, are inflation levels being impacted?
Fed Chair Jerome Powell has said that inflation is likely to pick up as the economy recovers from the pandemic, but he believes it will be temporary. Powell has also stated that the central bank plans to keep short-term rates anchored near zero through 2023.
As you read/hear about any potential changes to inflation we may be seeing this year, here’s a reminder about what inflation is and how it can affect you and your investments (this is a follow-up to my July 2020 blog on this similar topic, found here).
What Is Inflation?
Inflation is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.
Understanding the Consumer Price Index
- Food and beverages
- Medical care
- Education and communication
- Other groups and services
While it’s the commonly used indicator of inflation, the CPI has come under scrutiny. For example, the CPI rose 1.4 percent between January 2020 and January 2021 – a relatively small increase. A closer look at the report, however, shows the movement in prices on various goods tells a different story. Used car and truck prices, for example, rose 10 percent during those 12 months. Most people are seeing the prices of houses go up as well (fairly substantially too).
Investments & Inflation
When it comes to planning for retirement, one should not ignore the “inflation creep”. Inflation can affect investments in several ways. Most notably, it can reduce the rate of return, risk purchasing power, and influence the Federal Reserve.
Rate of Return
Inflation reduces the real rate of return on investments. Say an investment earned six percent over a 12-month period. During that time, let’s say inflation averaged about 1.5 percent. That would mean that your investment’s real rate of return would have been 4.5 percent – not six percent.
Inflation puts your purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer goods and services. In other words, inflation erodes the value of money.
The Federal Reserve
In addition, inflation can influence the actions of the Federal Reserve. If they want to control inflation, the Federal Reserve has several ways in which it can reduce the amount of money in circulation. Hypothetically speaking, a smaller supply of money means less spending – which could equal lower prices and lower inflation.
What we are seeing at the moment is the Fed being more patient. They are waiting to see actual increases in inflation, not going off of what forecasts predict. At a recent meeting, the Fed said they expect inflation to reach 2.4% this year and it actually wants inflation to rise above 2%. Despite4 that outlook, most Fed members are still projecting no increases in short-term interest rates until 2024 or beyond.
With so many changes over the past year or so, it’s no wonder investors and consumers are concerned about the inflation hype in the news today. When inflation is low, it’s easy to overlook how rising prices are affecting a household budget. And when inflation is high, it may be tempting to make changes to your financial standings and portfolio.
When projecting your investment growth, make sure you have accounted for inflation (3% is typically considered the norm). You’d be surprised how many “plans” I have reviewed over the years where inflation was not factored in. In other words, I’ve seen people’s projected retirement income stay the same over time…but it should be increasing over time to ensure they can still pay for things as they go up!
If you’re concerned about the inflation rates we’re seeing in 2021, your trusted financial partner can help determine if changes need to be made or if you and your portfolio are already well-prepared. In the near term, I think we’re OK with the levels of current inflation. Come 2023 and beyond…we are a little more worried.
Risk Disclosure: Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results.
This material is for information purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. The content is developed from sources believed to be providing accurate information; no warranty, expressed or implied, is made regarding accuracy, adequacy, completeness, legality, reliability or usefulness of any information. Consult your financial professional before making any investment decision. For illustrative use only.