The Importance of Understanding Inflation
You might have heard the saying, “A dollar today is worth more than a dollar in the future.” This is a popular quote regarding the time value of money. It illustrates the idea that a dollar in the future will not be able to buy the same value of goods and services as it does today. Consider, for example, the cost for a dozen grade A eggs in 1980 averaged $0.84, while the average price for the same type of eggs in 2019 was $1.54. Since, to our knowledge, these newer eggs did not come with any additional bells-and-whistles, the reason the price nearly doubled in that time frame came down to one factor—inflation.
What is Inflation?
Plain and simple – inflation is the rate at which the price for a good or service rises over time. Due to this rise, a dollar in today’s terms would buy less than it did in prior years.
This principal of inflation not only affects goods and services, but also financial goals. Inflation has a strong impact on retirement savings, education savings, home/vacation savings, etc. To explain how inflation affects your savings, let’s look at an example: You have $100 today. There is an item you want to purchase for $100, but instead you keep the cash in your house for one year. If inflation during the year is 5%, and you want to buy the $100 item from the prior year, it will now cost you $105.
Here at B&C Financial Advisors, we help you plan for these various expenses by creating what is known as a Cash Flow Analysis. This report is comprised of your total assets, any planned contributions or withdrawals, the time horizon for your investments, an agreed-upon rate of return, and an inflation figure. The analysis shows a visual representation of the likelihood of reaching your financial goals and whether you will outlive your money. This is based on a set of parameters which are subject to change and are routinely updated throughout the planning process. For those familiar with this report, we factor inflation into the calculation in the form of a cost-of-living adjustment (COLA).
There are several reasons for factoring inflation into your financial plan, including:
1. To make sure your assets are keeping up with inflation;
2. To ensure your retirement/financial goals are met considering the assumed inflation rate; and
3. To account for the increased costs of future purchases (weddings, homes, cars, etc.)
Hedges Against Inflation
There is no perfect hedge against inflation risk, but there are a few options to mitigate the impact inflation plays in your personal and financial life. Some of these options are listed below:
1. Reallocate Your Portfolio: While past performance does not guarantee future results, historically the stock market has outpaced inflation. Therefore, reallocating a portion of your portfolio out of bonds and into dividend paying stocks may help protect your portfolio from being outpaced by inflation.
2. Buy Gold: Gold has been considered an inflation hedge for many years. This asset can be a shield against a falling dollar. As inflation rises and wears down the value of the dollar, the cost of gold rises as a result. However, gold is not the perfect hedge against inflation. When we are in a rising inflation environment, the central bank of the U.S. (The Federal Reserve, or “The Fed”) tends to increase interest rates as part of monetary policy. Holding onto an asset that pays no yield, such as gold, is not as valuable as holding onto an asset that does. This correlates with our first option of putting a larger percent of your money into dividend paying stocks.
3. Purchase TIPS: Treasury inflation-protected securities (TIPS) are a type of U.S. Treasury bond indexed for inflation to protect investors during those higher inflationary times. TIPS payout a fixed rate semiannually, but the principal value is reset according to changes in the Consumer Price Index (CPI). Currently, these bonds do not imply exceptional returns, but if the inflation rate does increase, they are likely to outperform treasuries and many other fixed income assets.
4. File for Social Security Strategically: Social Security income has a built-in inflation hedge, as payments are adjusted for changes in the CPI each year. This is more impactful for some people, depending on the size of their social security payment relative to their monthly or annual cash needs. Another factor that can be used to “hedge” against inflation as you age is to delay filing for Social Security which increases the monthly payment from social security.
The Federal Reserve Vs. Inflation
The Fed recently gave vague guidance on how they will monitor inflation in the future. It has decided to let inflation run higher and unemployment go lower before it will look to tighten these conditions to more normal levels. In the past, the Fed has used different tools and rules to help them decide when to tighten or loosen monetary policy. However, these guiding “rules” have not worked perfectly in the past, and the Fed is looking to modify their arsenal to a certain extent.
Since January of 2012, the Fed has had a clear inflation target of 2%. That all changed with Fed Chair Jerome Powell motioning the Central Bank will allow inflation to go above its 2% target by an unspecified amount for an undetermined period before tightening monetary policy again. The Fed adopted an average inflation targeting strategy that attempts to achieve above-target inflation to compensate for periods of below-target inflation. This sounds somewhat simple, but without a formula to define an average, the Fed’s interpretation of average is subject to change. This new shift is aimed at advancing inflation after years of falling short of the 2% target and as a result hurt the central bank’s ability to help fight recessions. The Fed will meet again in September, hopefully giving more guidance on their long-term approach and how this change will influence near-term policy.
If inflation is not included in your financial plan, the total amount you have estimated you will need to reach your goals may fall short. Therefore, we feel it is prudent to factor inflation into your planning scenarios to avoid this potential setback.
The information presented in this article is for educational purposes only and is not meant to provide individual advice to the reader. There is no guarantee the information provided above relates to your personal situation. All financial situations are unique and should be advised as such.