As we move to the middle of 2021, one thing is clear — inflation is back. For decades, most people almost ignored inflation, but it may be hard to ignore it in the future.
Inflation is simply another term for rising prices. While the causes can be obscure, the effects are very real for everyone, no matter their income.
You’ll likely first feel higher prices in everyday goods and services like food, fuel, and healthcare, but from there, inflation affects the economy in surprising ways. Things like mortgage rates, returns on stocks, returns on bonds, and the overall trajectory of the economy are all directly influenced by inflation and forward-looking inflation expectations.
The Federal Reserve spent decades keeping inflation as low as possible, but now it is actively pushing for more inflation to demonstrate it’s doing everything it can to support the economy. It used to look at 2 percent inflation as a ceiling, but now it is looking at using that rate as an average target that can be exceeded to get the actual average closer to 2 percent.
Today we understand prices are rising, but it doesn’t really affect our decision-making yet. I had a mentor who lived through the inflationary period of the 1970s and 1980s, and he would always tell me, “Inflation is a mindset.” He said in the 1970s he faced strange dilemmas, like “I better buy a new car this year because by next year, I won’t be able to afford it.” This was a period where his income was actually rising quickly, but he felt prices were rising more quickly, and therefore inflation colored all his decisions.
Inflation, in moderation, is actually a good thing. A deflationary environment —where your money increases in value each year — sounds great, but in practice it’s even worse than the reverse. The opposite sentiment to the one my mentor followed — “I might as well wait until next year to buy a car because it will be cheaper.” — can be devastating. Severe deflation will grind an economy to a halt.
The best and fairest environment for everyone is a world of stable prices, defined by most as inflation of 1-2 percent a year. We’ve enjoyed that regime for quite some time, but it looks like, at least for a while, we’ll experience inflation numbers greater than 2 percent.
How can you prepare?
The biggest way is to adjust your thinking. When inflation becomes meaningful, try thinking in real returns rather than nominal returns.
To explain, let’s look at current certificate of deposit (CD) rates. If you buy a one-year, $100,000 CD today, you might get a 0.50 percent nominal rate, meaning you’ll have $500 more after a year. In a world of 2.5 percent inflation, your purchasing power goes down overall by about $2,500 during the year. Taking both the interest and the inflation into account, the real rate on that CD is about -2 percent. That loss of about $2,000 is hard to see, but it is very real. It will feel real, too, if inflation creeps up much more than it already has.
Even at a reasonable 2.5 percent annual inflation rate, something that costs $100 today will cost $128 in 10 years. If you stuck a $100 bill under your mattress for that decade, you might think you broke even, but you would have lost 28 very real dollars of purchasing power during that time. Whatever the trajectory of inflation might be, thinking in real returns always makes sense.
The Fed has good intentions with regards to its inflation targeting, and it may get it exactly right with no overshoot. Whether or not it does, thinking in real rather than nominal rates gives you a more realistic approach.
Gene Gard is Co-Chief-Investment Officer at Telarray, a Memphis-based wealth management firm that helps families navigate investment, tax, estate, and retirement decisions. Contact him at ggard@telarrayadvisors.com.
