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You may have noticed it costs almost twice as much to fill up your car at the pump relative to last year, or that the pack of the ribeye steaks you get every week is getting expensive. On average, according to the Bureau of Labor Statistics (or BLS), the cost of living has been increasing at a rate above 5% over the past 12 months. This unusually high number (inflation averaged about 2% a year over the last 20 years) generated many headlines and you may wonder what it means for your retirement plan and for your future investment returns.
Before panicking about inflation and making any drastic changes, however, it is helpful to understand how inflation works and how it can impact your investment plan. Following is a brief look at inflation and how you can plan for it.
What is inflation?
Inflation is a general increase in prices and the cost of living. Over a given period, the prices of some of the goods we consume increase (think a gallon of milk or a box of cereal) while others may decrease (the price of TVs). Inflation measures the average increase in prices. If prices go up on average, it becomes more costly to purchase the same goods and services as before the price increase, so the cost of living goes up. The Bureau of Labor Statistics publishes the most common measure of prices, called the Consumer Price Index or CPI.
When prices increase, the cost of living goes up and so does the CPI. The CPI uses over 200 categories of goods and services divided into eight major categories and collects prices on these goods monthly from 75 different metropolitan areas. The BLS then constructs the CPI by weighting the prices of each good and service based on how much a typical household spends on each of them. For example, the typical household in the BLS sample spends 15% on transportation, and so the transportation category gets a 15% weight. Below is the breakdown of the latest CPI basket.
Over the last 12 months, the main sources of inflation have been energy costs, including gasoline and utilities, and transportation, including the prices of used cars. More recently, you may have noticed higher prices at grocery stores and restaurants. There may be differences across US states and regions, which result in different baskets and different changes to the cost of living. The BLS website makes available CPI information at a regional level.
Why is Inflation Bad?
The most obvious effect of inflation is that it lowers the purchasing power of your income or real income. For example, if you got a raise of 3% at the beginning of 2021 and the cost of living goes up by 5% this year, your real income is declining by approximately 2% this year. While incomes tend to adjust to inflation somewhat over time, not everyone’s income will move in tandem with inflation, and so high inflation can mean a decrease in your real income, which can be particularly bad for a retiree living on fixed incomes.
Another cost of inflation is that it increases effective tax rates. Income raises that are caused by inflation can put you in higher tax brackets while your real income stays the same. Inflation also increases the taxation of your investments. Suppose your return is 5% when inflation is also 5%. Your real return is zero because you made just enough to cover the increase in the cost of living. However, you are taxed on the full 5% return.
There are also more general costs to inflation. In periods of high and unpredictable inflation, economic growth and stock returns tend to be lower. In the decade between January 1970 and December 1979, inflation averaged 7.4% per year, while the S&P 500 Index averaged 5.9%, lower than inflation, and below its long run average of over 10%.
There are some positive aspects of periods of inflation. If you have a fixed rate mortgage, your monthly payments relative to your (inflated) income will be smaller. And in many cases, at least if inflation is temporary, you can greatly reduce its negative impact by changing your spending habits, as we discuss below.
Government Policy and Inflation
Government policy, whether monetary or fiscal, tends to be inflationary. Increased government spending financed by the purchase of government bonds by the Federal Reserve System (“the Fed”) is inflationary. Purchases of existing government bonds by the Fed to increase the money supply can also be inflationary, particularly if the Fed insists on achieving maximum employment. If inflation gets out of control, historical experience shows that the cure can take a long time and cause slower growth and higher unemployment for a while, as we experienced through the 1970s and early eighties.
What can you do?
You may be tempted to follow the news and various experts trying to predict inflation and picking investments that might do well if inflation goes up. However, historical experience shows that unfortunately, we cannot predict the future of inflation with any reliability. We can only trust that the Fed will use its tools to keep inflation under control, and not necessarily that they will be successful. Similarly, do not rush to buy gold or other commodities to protect your nest egg against inflation. Research shows that gold is not a good “hedge” against inflation for most investment horizons. Current prices also show that gold is expensive relative to the CPI, based on historical evidence (the current Gold-to-CPI ratio is 6.5 vs. the historical 3.5). So what can you do? Here are some suggestions that do not rely on predicting the future.
Make a Plan
If inflation causes you to worry, make sure you have a good financial plan in place for your goals. Whether you are planning for future retirement, evaluating your retirement readiness, or estimating the amount you can safely withdraw from your nest egg, a financial plan that considers multiple inflation scenarios through a Monte Carlo simulation is a good way to be prepared for inflation risks. Historically, we have experienced periods of high inflation and of low inflation, high interest rates and low interest rates, etc. Your plan should be robust to a range of scenarios.
Stick with the process of planning
Making a plan is a first step, but planning is a process. Make sure you revise your assumptions and your plan as your financial picture evolves. Currently, you may want to be more careful about spending with rising inflation, as we suggest below. But inflation fears may be temporary. The economy may get back on track and you may get a raise that is greater than expected, or your investment returns may be better than expected. You should build some flexibility in your plan and revise it often, once or twice a year.
Make a budget and track your spending
A budget gives you clarity about your spending habits and can help you find opportunities to save. Check out this post to create your first budget or this one to help you track your spending. Here are some ways to reduce spending in periods of higher inflation. First, keep your durable goods longer. Wait on buying your next car if you can, so you can avoid the temporary price pressure. Buy used. You probably don’t need a brand new SLR camera or mountain bike if you are just trying out a new hobby. The local facebook marketplace is an ideal place to shop.
Cut on your driving and save on gas, which has risen over 30% in some parts of the country. Take a hike and check what your neighborhood has to offer. If you have to fill up, according to gasbuddy.com, a website to help you save on gas, Monday and Tuesday are days with historically cheaper gas prices. Finally, if you like traveling, explore cheaper destinations to save on travel, and explore places that are closer to home.
Refinance your debt
If you haven’t taken advantage of historically low interest rates yet, you may want to consider refinancing your mortgage or other loans. Low interest rates mean the price of borrowing money is particularly low. Reducing the costs of your loans means you have more money to help with other costs that may be rising.
Review your portfolio
I put this one last since a good portfolio allocation should always consider the effects of inflation, regardless of the headlines. A retirement portfolio should have some exposure to inflation protected treasury bonds, or TIPS. Unlike gold or other commodities, TIPS are a good hedging instrument because the bond payments are adjusted by the actual CPI. Although limited to smaller amounts, I-savings bonds are also a good inflation instrument to consider, and can give you higher returns than TIPS.
Finally, long term investing benefits from exposure to stocks. Historically, stocks have outperformed inflation and commodities like gold over the last 50 years. How much in stocks vs bonds should depend on your goals and time horizon, and not so much on current inflation fears, so start there.
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You get the point. The bottom line is that there is no silver bullet against unexpected inflation. It is simply one of the risks that investors have to take into account when developing their investment strategy. If you don’t have a strategy or you want to review yours, get started by reviewing our discussion about the risk-return tradeoffs of investing, and how to build your own investment guidelines.
Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.
