Let’s Talk About Inflation

We probably all know what “inflation” is; in the customary use of the word it simply means the rate of increase in the prices of things we purchase.   Economists like to debate the best way to measure inflation.  Is it more useful to measure existing inflation or to measure expected inflation?  Sometimes you might hear people talk about so-called “core” inflation, which actually leaves out some core purchases with a lot of price volatility in the short term, like gasoline.  By the way, “dis-inflation” is the term used when prices are dropping, or you can say “deflation” or “negative inflation”.  Economists like to debate which term is better here too, often when they are talking about Japan, which has suffered from a lack of inflation for decades.  A little bit of inflation is usually considered a good thing.  It encourages people to buy things before prices go up, so it helps an economy to grow.

Even if we all know the meaning of the term inflation, who can remember the last time inflation was a real threat in the U.S. because it was too high?  We simply haven’t had to worry too much about inflation for a long time.   In the U.S. we have become quite accustomed to hearing that inflation is very low and barely changing.  Keeping it that way is one of the three mandates given by Congress to our central bank, the Federal Reserve.  Financial Planners know that none of the popular measures of inflation are exactly right for any particular investor—each person has their own personal rate of experienced inflation, which for some people might be more about the cost of transportation, or healthcare, or housing, or food, or education.  And a good financial plan will deal with that by separating out those risks, and not just accepting one number for expected inflation.

If we can settle on the Consumer Price Index (or CPI) as our measure of inflation, then here is a bit of historical trivia for everyone.  When was the last time the CPI was above 5% for more than a year?  The answer is…1981, four decades ago.  The CPI was 8.9% in 1981 after a couple of even worse years.  In 1980 the CPI was a whopping 12.5%, and before that in 1979 it was even higher at 13.3%.*

Many of our clients may recall what it was like to make a trip to the grocery store four decades ago and see that the price of staples like a gallon of milk were higher every week.  Or they may remember how much the price of that new car featured on the “Price is Right” just kept climbing.  Maybe they remember that sinking feeling of getting a modest raise at work, if they got one at all, because in 1980 we were in a recession, when inflation was in the double digits.  The corrosive effects of high inflation on our purchasing power can be economically devastating for consumers.  And that is why financial planners worry about it.

Here is another question for you.  How many of you were investors four decades ago?  If you were an investor at the beginning of 1980, you could have earned 11.4% just by investing in 3-month Treasury Bills (and something close to that for holding onto cash in the bank or from buying short-term CDs.)   That didn’t keep up with 12.5% inflation for that year, but it was close.  Usually when we see high inflation we see high interest rates.  Maybe you owned a U.S. fixed income portfolio of varying maturities to try to lock in those high rates.  That might have only been up 2.7% (as approximated by the Lehman Brothers Aggregate Bond Index at the time, commonly called the “agg”.)  The index did so poorly, when compared to inflation,  because it approximated how a bond ladder would react.  Rising inflation and interest rates can clobber the price of bonds, eroding the return enjoyed from high rates. There weren’t any good choices for keeping your money safe.*

This history lesson raises the question—is any investment “inflation proof?”  In 1980 you could come close with cash, but that might be a lot harder today.  In 1980 the S&P 500 did rally pretty hard, and was up 31.7%.*  So stock market investors did better than most workers and that return clearly beat the rate of inflation.  But we all know, at least I hope we have learned, that we can’t count on the stock market to reliably give us what we want when we want it.

Right now, and for the foreseeable future, investors must choose between Capital Preservation and Safety.  The only truly safe and predictable investment is cash or some kind of cash equivalent, such as very short-term CDs or Treasury Bills.  But that won’t keep up with inflation.  Stability in your portfolio is actually a guarantee of loss, after adjusting for inflation.  Investing in long-term bonds probably isn’t the right choice, just like it wasn’t in 1980.  Capital preservation means you end up with more money than you started with, after inflation, and right now that requires accepting some amount of risk.

As we’ve presented in the last two Quarterly Market Reports, the Federal Reserve is now laser focused on moving the economy towards full employment, and is apparently willing to let inflation get meaningfully worse, worse than it’s been in decades.  It is perfectly logical to keep some of your resources in cash to satisfy short-term spending needs and to have an emergency reserve.  But cash costs.  You might be losing 2% to inflation, but that could rise to 3%, or 4%, or more, before the Federal Reserve takes its foot off the gas.  How many years are you willing to do that?

And so investors will have to decide what risks to take.  We’re going to get into specifics, and tell you how to do that, in the Second Quarter 2021 Quarterly Market Report, presented by BIP Wealth Chief Investment Officer Eric Cramer.

*Data source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html

Disclosure: This communication contains general investing information that is not suitable for everyone and is subject to change without notice. Past performance is no guarantee of future results and there is no guarantee that any views and opinions expressed will come to pass. The information contained herein should not be construed as personalized investment advice, tax advice, or financial planning advice, and should not be considered a solicitation to buy or sell any security. Investing in the stock market and the bond market involves gains and losses and may not be suitable for all investors. The U.S. Fixed Income index is the Bloomberg Barclays Capital U.S. Aggregate Bond Index (formerly the Lehman Brothers U.S. Aggregate Bond Index), which is a broad-based benchmark selected as the best available proxy for a high quality, diversified fixed income portfolio suitable for a U.S. investor. It is comprised of the Barclays Capital U.S. Government/Credit Bond Index, the Mortgage-Backed Securities Indices, and the Asset-Backed Securities Index. It is an unmanaged market value-weighted performance benchmark for investment-grade fixed-rate debt issues, with maturities of at least one year, and an outstanding par value of at least $100 million. The S&P 500 Index is a market-capitalization-weighted index of the 500 largest U.S. publicly traded companies, and is a float-weighted index, meaning company market capitalizations are adjusted by the number of shares available for public trading.  It is not possible to invest directly in these indexes or any other index.