What is inflation?
Inflation is the rate at which prices change over time. For example, if something costs $1 today and $2 a year from today, its price increased 100%, or it has a 100% inflation rate. If the price of something increases from $1 to $2, and you only have $1, you can no longer afford that item. Your money has less purchasing power.
That’s the essential risk that comes from keeping money in cash. Even “normal” inflation (the average inflation rate is around 3% a year) means that your money will buy less over time. When inflation is high, like in 2021 and 2022, that risk is even greater. Something that cost $1 in early 2020 might cost around $1.25 in 2023—a stark increase in a short period of time.
Those numbers sound dramatic, and they are, but it’s also important to note that some inflation is normal and healthy in an expanding economy. While things cost more now than they did in 1950, the U.S. economy also expanded significantly during that period. The relationship between the inflation and the economy, as well as the relationship between inflation and investments, can be complex. So, before we get into that, let’s look quickly at how inflation is calculated.
How is inflation calculated?
The Department of Labor uses the consumer price index (CPI) to track the prices for a “basket of consumer goods and services”—things like food, personal care products, medical expenses, and so on.
While CPI is the primary inflation tracker, it does have some limitations. For instance, the government bases the basket on actual goods consumers report buying, so there’s a delay between the prices consumers share and the data release. CPI reflects prices in urban areas, not rural. And, finally, some of the larger monthly expenses most Americans pay aren’t tallied by CPI, such as health care and housing. (CPI tracks out-of-pocket medical expenses but does not track health insurance premiums.)
Despite these limitations, CPI numbers influence a significant amount of government and monetary policy.
The government tracks a second inflation indicator that’s discussed a bit less frequently: producer price index (PPI). This tracks inflation from the perspective of producers, and strategists often watch this number as an early indicator for consumer prices.
How does inflation impact the economy (and investments)?
Inflation impacts the economy (and investments) in myriad ways. Let’s look at a few considerations before looking at some of the ways these different factors intersect.
· Prices don’t increase uniformly or for uniform reasons. In 2022, food and energy prices drove inflation in many areas. The degree to which you and your family feel inflation may depend on both your household spending habits and the sector of the economy you work in.
· Companies may want to increase wages to help employees keep up with the increased cost of living.
· Both wage and price increases may become permanent. It’s hard to lower an employee’s salary following an increase, and if companies realize consumers will pay more, higher prices tend to stick.
The government response to inflation impacts the economy and investments, too. It’s the Federal Reserve’s job to maintain price stability, and it often uses interest rates to do so. Multiple things happen when the Fed raises rates, including:
· Companies that previously used debt to fund growth may stop or slow those investments. This can cause layoffs and may even slow economic growth overall.
· Higher mortgage rates may cause the housing market to slow.
· Higher credit card rates may cause consumers to think twice before charging items. Less consumer demand can help bring prices down, but it can also create problems for businesses.
Now, let’s consider how some of these factors fit together. A company might see demand for its services fall while employees simultaneously ask for cost-of-living raises. Maybe the rate on its debt increases, too, and profits fall. If it’s a publicly traded company, this kind of financial pressure might cause share prices to fall.
The bond market is impacted as well. New bonds might be issued with higher coupons to reflect higher interest rates, which drives down the price of existing bonds. (This refers to bonds traded on the secondary market; if you buy an individual bond and hold it to maturity, its face value won’t change.)
Risk tradeoffs
As you can see, inflation is complex, both in terms of cause and effect. Diversification may help address some of this complexity, as it can help account for the multiple factors at play during uncertain times.
Some investors want to sell investments, preferring to keep money in cash as they wait to see how things play out. However, avoiding market risk by putting money in cash leaves that cash susceptible to inflation risk.
Creating an investment strategy and financial plan is often about balancing competing risk factors. Ultimately, the only way to stay ahead of inflation risk is to invest your assets so that your returns, after tax, are greater than the rate of inflation. At Quorum Private Wealth, we can help you analyze these risk tradeoffs alongside your family’s priorities and goals.
Sources: Bureau of Labor Statistics, Minneapolis Federal Reserve, CME Group
