What is Inflation and Why Should We Care if it’s Too High?
In Q3 2021, prices continue to rise across many sectors, and Q2 saw inflation and asset prices increase beyond what we saw in Q1. What is inflation? When consumers and sellers have the expectation that the currency they hold today will buy a smaller bundle of goods and services tomorrow, we call the effect on prices “inflation.” Stated simply, inflation is the decline of purchasing power of a given currency over time, typically measured by the increase in price of a standard bundle of goods. It is straightforward to see that a small amount of inflation has a stimulating effect on economic activity, encouraging consumers to spend in the short-term lest their savings buy fewer goods tomorrow. In fact, the Federal Reserve targets an average annualized inflation rate of 2% over the business cycle. But if inflation advances too quickly, mass buying creates shortages. Wages often lag increasing prices, consumers can lose confidence in their ability to afford goods and services in the future, medium and long-range. Planning by businesses and individuals grinds to a halt, and economic activity and personal financial well-being contracts as a result. In short, it makes it hard to make a financial plan, business plan, or life plan if one can’t count on their income and savings to afford life’s essentials. When inflation spikes up and stays high for too long, central banks have learned that only increases in interest rates, which contract economic activity, can reset the stage for future growth. The US experienced significant inflation in the 1970s, and painful monetary policy in the form of markedly higher interest rates was required in the early 1980s to bring price stability so the economy could grow again. Inflation can have myriad causes from too large a supply of money, interest rates too low for the current economic conditions, restrictions in supply of key components of economic activity, spikes in demand for core goods or services, or loss of public confidence in the full faith and credit of the government backing the legal tender, among others. Keeping these concepts in mind is helpful when thinking about the forces at play in markets and their effects on people’s ability to spend, save, invest, and plan their lives.
Economists, policy makers, and investors have been caught by surprise by the magnitude and timing of the jump in economic activity and prices. In January, the Congressional Budget Office projected 2021 US economic growth at 3.7%. On July 1st it projected it at 7.4%. The median economist forecasting US inflation in February predicted America’s core consumer prices would rise just 1.9% over 2021; projecting first half numbers over the full year has some economists expecting 2021 annualized core inflation to push above 8%. Some “baseline effects” related to the short-term drop in prices immediately after the 2020 COVID-19 outbreak are magnifying the increases in this year’s metrics, but the spark of inflation is real, and larger than expected. The big question is whether the rate of price increases will continue or settle back as supply and demand adjust to the world after the worst of the COVID shutdowns we saw in 2020?
On balance, it appears likely to our Investment Committee that most key drivers of high inflation will be limited in duration, and few will persist at their currently high levels in the medium to long-term. That said, we believe we are likely in an environment of higher inflation than we've seen in decades and that the Fed is likely to let inflation run above its target average of 2.0% to some degree in the hopes that the economy will move closer to full employment. The Fed has stated as much, as they are in pursuit of more job creation in the US economy, and it’s clear they have more confidence in their tools to tamp down inflation should it persist than they do in their tool kit to spark economic growth should it flag.
Inflation can Erode Retirement Savings’ Buying Power
We’ve been recommending to clients that they review their full balance sheets with us. While the magnitude and duration of inflation is not predictable, it makes sense to plan investments with an eye to the possibility of elevated medium-term inflation and potential countermeasures central banks may eventually take to rein it in. Evaluating assets that could suffer in an inflationary environment is sensible in the context of your long-term financial plan and current holdings. If you haven’t evaluated your investment accounts with inflation and the long-term in mind, reach out to us at Van Hulzen Financial Advisors for a fresh perspective.
Written by author: Nathan Torinus | Chief Executive Officer
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