Have you been to the gas station lately? I have, and it wasn’t fun. For the first time, I paid more than $70 for a fill-up! I was reeling for a moment—until I realized I was reacting precisely as my dad did to the price of a loaf of bread. My father was a dedicated investor and was wise about money (you can read more about him in my old blog post Lessons from Dad). Yet, he had a running commentary on rising prices and the pain of inflation. As he watched the cost of everything from bread to cars to coffee to housing climb, he had a familiar refrain: “How can a loaf of bread cost that much?” “The price of this car is more than I spent on my first house!” I’m sure he felt the same way I did at the gas pump: gouged.
As we anticipate another period of inflation (and yes, it is coming), the media has warned consumers and investors to prepare for disaster due to rising prices, increasing interest rates, and a decline in purchasing power. But as contrarian as it may seem, none of that is necessarily a bad thing. When my dad was 30 years old, a loaf of bread cost just 12 cents, and the average annual salary was $3,300. Twenty years later, he hated paying more than double for his bread (for which he now paid a whopping 25 cents), but the average salary had risen about 3x, to just under $10,000. In real purchasing power, bread was cheaper in 1970 than it was in 1950.
Economically speaking, it makes sense, but that doesn’t make it feel any better when you’re in the thick of it. That’s because, by definition, inflation is “the decline of purchasing power of a given currency over time.” Things feel more expensive, regardless of the big picture. After four decades of record-low inflation rates and a decade of historically low interest rates, we’ve become accustomed to stable prices. Today’s college students have never experienced inflation. If you’re struggling to adjust, here are some quick facts and tips to help reset your financial brain back to normal:
- Inflation goes hand in hand with economic growth.
Everyone loves to hate the idea of inflation, but we love the idea of economic growth. Yet, economic growth is what often drives inflation! When the economy grows, consumers have more purchasing power. We buy more, and that increases the demand for all sorts of goods. When demand outpaces supply, prices go up. Higher demand also leads to more jobs, which causes unemployment rates to fall… which creates labor shortages, which drives up wages, which accelerates inflation. This is how a healthy economy works.
- Inflation increases the price of certain assets.
If you hold assets that are priced in dollars, inflation is likely to push up the price of those assets. Examples are everywhere. Home price inflation has been accelerating across the US, and one of the best ways to hedge inflation is to own stock in growing companies that can pass commodity prices (think lumber) to consumers.
- Inflation decreases the value of cash savings.
In contrast, inflation usually hurts cash holdings. The personal savings rate in the US skyrocketed to 32% in April (one silver lining of the pandemic). While saving for your freedom fund is always wise, if your savings are in a CD or other fixed-rate vehicle, your purchasing power essentially depreciates. While interest rates may rise during inflationary periods, the return on cash generally does not outpace inflation.
- Inflation decreases the value of pensions and Social Security income.
Most pensions are paid in fixed dollar amounts over one’s lifetime. Some pensions include some cost-of-living adjustment (COLA), but the COLA is often less than the change in the Consumer Price Index (CPI). Social Security provides an annual COLA, but it uses a chained CPI that climbs more slowly than core inflation. In both cases, as prices rise, the dollars in your wallet won’t keep pace. To protect your buying power, offset your fixed income with a diversified retirement portfolio designed for growth.
- Inflation requires a strategy to outpace inflation risk.
The best way to protect your purchasing power against inflation over the long term is to accept an optimal level of investment risk. The right amount of risk increases the value of your assets faster than inflation drives down the value of every dollar. And that does so without threatening the health of your portfolio over the long-term. Without portfolio growth, many retirees feel poorer and poorer with each passing year. Investing in equities/stock funds is the only way to get ahead of inflation (and taxes, too, but that’s for another blog post).
Ten years from today, we may have to pay $100 to fill the gas tank or spend $8.50 for a Grande Latte. During the earning years, inflation can benefit you with big raises and the growth in your 401(k). Once you’re retired, you have to continue to invest for growth rather than ‘income’ so you can avoid the inflation squeeze. If you want to dive deeper into the impact of inflation, I recommend this article from Dimensional Fund Advisors. If you want to take a closer look at your financial plan and investment strategy to ensure you are prepared to thrive in a world of rising inflation, I am here to help!
 According to the U.S. Bureau of Economic Analysis