A year into a pandemic, and several stimulus packages later, various media pundits and economic/policy experts have begun to raise alarm about higher inflation. How we define inflation, and how much inflation actually occurs, are both important factors for how you could respond to these changes in the 2020s.
Inflation is the increase in cost of goods and services over time. In general, healthy economies tend to experience a gradual increase in the price of things. There are a lot of ways that economists try to measure “average” inflation across an economy, which is important to the US Federal Reserve’s overall monetary policy decisions.
One classic indicator is the CPI (Consumer Price Index), which tracks a typical “basket of goods” that the average consumer purchases and looks at price changes over time. This is a rough estimate since it misses various things, like substitution from one good to a cheaper product that might not be tracked in the “basket”, or indirect payments (e.g. capturing the change in health insurance premiums and out-of-pocket costs, but not what a private insurance plan pays out for healthcare on a person’s behalf).
Some people assume that the Fed only uses CPI, but the Fed actually tracks several measures, such as the PCE (Personal Consumption Expenditure) when weighing monetary policy decisions. Since PCE includes consumer changes (like substitution), it tends to provide a more robust inflation estimate than CPI alone.
Regardless of index used, remember that these are averages; your personal rate of inflation is what you probably care about most.
Fortunately, that’s easy to calculate: just keep track of your expenses! For a given year, your “personal inflation rate” is [($ spent in current year)/($ spent in previous year) – 1]*100%. If you group some of your expenses, you can also figure out your personal inflation rate in categories (e.g. groceries).
How Much Inflation?
Let’s consider a national-level estimate for our measure of “inflation” (feel free to apply the same logic to the personal inflation you face). There are three plausible scenarios to consider for the next few years:
- Staying the course with low-to-average-target (2%) inflation
- “Running hot” (up to 4% inflation) to balance years of lower-than-average inflation
- High inflation, which, in a worst-case scenario, reaches levels of “hyperinflation”
I’m not going to spend much time on how likely each scenario is. I personally believe that somewhere between average to a little above-average inflation is most likely, and that double-digit or higher inflation is improbable, but not impossible. Regardless of what you believe, we can examine each grouped scenario, its potential impacts on the economy, and potential adjustments from a personal finance perspective.
Case 1: “Staying the Course” with Low-to-average inflation
Economic impact: the low interest rate environment that people have gotten used to over the past decade continues. Companies take advantage of low interest rates to borrow funds for growth, the short-term price fluctuations people saw over the past year smooth out as supply chains get back on track, and things continue chugging along.
Who benefits: People who need/want more debt (e.g. getting a 30-year fixed-rate mortgage with an interest rate of 2% is great when that same mortgage would have had an interest rate of 4% a few years before). Growth companies that need to take on a lot of debt benefit from the low cost of borrowing to drive forward long-term projects, as long as they are carefully managing their debt should inflation run higher further in the future.
Personal finance adjustments: not much change needed, although if you have a ways out from retirement, it could be worth investing more heavily in stocks than bonds. Low borrowing costs means that quality bond yields will also be fairly low.
Case 2: “Running Hot” (up to 4% inflation)
Economic impact: prices are rising a little faster than the target 2% inflation. The Fed expressly stated it’s willing to allow this to compensate for years of below-average inflation, as long as things don’t appear to be getting too out of hand.
Who benefits: the Fed and people who want more debt (maybe). In exchange for running hot for a couple years, higher levels of inflation will allow the Fed to incrementally increase their federal funds rate over time, giving them more room to lower rates and smooth out a future recession. Likewise, if rates do stay lower even as inflation is a little higher, people might want to take on more debt for projects if they believe they can earn a higher return on investment (ROI) than the interest rate.
Personal finance adjustments: check if any of your debt has variable-rate interest and lock it in at current lower rates. Beyond that, staying the course in the stock market and other equities is probably a good idea, since their revenues may benefit from price increases.
Case 3: High Inflation
Economic impact: uncertain, but probably not good.
People who were adults in the 1970s likely remember “the great inflation”, where then-Fed Chair Volcker used extreme contractionary monetary policy, increased the federal funds rate to 20% (the federal funds rate has been less than 5% since 2008), and got inflation under control. While this successfully prevented hyperinflation and re-established the credibility of the Fed, it also triggered a recession.
The other thing to consider is debt. In the United States (as with many other countries across the world), the national debt continues to rise, and in periods of higher inflation, more debt being issued to pay off previous (and lower-interest-rate) debt could rapidly increase obligations.
Who benefits: People who hold a lot of fixed-rate debt with the means to pay it off, and lenders. Suppose you have a fixed-rate mortgage at a 4% interest rate, inflation is 10% (quite high), and your salary just keeps pace with inflation. Your mortgage payment will be the same, but your gross income increased 10% this year, and chances are that your home value also increased. Conversely, if you’re the mortgage lender and can lock someone in at a 13% interest rate (or convert a lot of adjustable-rate mortgages from 4% up to 13%), you’re suddenly making a lot more money.
Who gets hurt: Cash-in-hand savers, people on fixed incomes, and people who need/want more debt.
If inflation is 10%, and you keep $10,000 under the mattress for a year (or only get $10,000 from a private pension or annuity), it’s only going to be able to buy $9,000 worth of equivalent goods a year later. Likewise, growing companies need to have higher ROIs to make new investments worthwhile (8% ROI might have been good before, but if inflation is 10% that project is now going to get discontinued).
Personal finance adjustments: Bonds might be a better investment now, including federal bonds like TIPS (Treasury Inflation-Protected Securities). If you snag some high-yield bonds from reputable companies and inflation gets tamed soon after, then you might luck out with locking in high yearly returns (but on the flipside, if inflation doesn’t get tamed, you might “only” get returns of 10%/year while inflation rises to 18%).
Tangible assets, like choice real estate or gold, may also do well as stores of value (but it’s not guaranteed — changes in supply and demand happen in all markets over time, and what worked historically may underperform the next time around).
Finally, you can hedge against higher inflation in your everyday purchases. Buying longer-lasting food items in bulk (e.g. dried beans, rice) reduces your budget’s exposure to inflation at the grocery store. Likewise, purchasing a hybrid or electric car cuts out potential inflationary pressures you could face from rising gasoline prices.
This is my snapshot opinion, not professional advice, and I hope it helps map things out a little more. By planning ahead, we can better respond to a variety of scenarios based on what actually happens with inflation.