Following a year of economic instability, it appears that many of us are turning our attention to something that has been around for decades, but has recently piqued national interest: inflation. In fact, a recent study found that people are Googling the word “inflation” at a rapid rate, with a peak not seen since 2008.
Since the start of the COVID-19 pandemic, six major stimulus bills totaling around $5.3 trillion have passed. With these efforts to alleviate pandemic-fueled financial strife, are inflation levels being impacted?
Fed Chair Jerome Powell has said that inflation is likely to pick up as the economy recovers from the pandemic, but he believes it will be temporary. Powell has also stated that the central bank plans to keep short-term rates anchored near zero through 2023.
As you consider any potential changes to inflation we may be seeing this year, here is a reminder about what inflation is and how it can affect you and your investments.
What is Inflation?
Inflation is defined as an increase in the average level of prices for goods and services. Due to inflation, year after year, money has less buying power. In 1980, a one-pound loaf of bread cost only 50¢. Today, a loaf of bread costs closer to $1.50. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.
Understanding the Consumer Price Index
The CPI was developed based on information provided by families and individuals on purchases made in the following categories:
- Food and beverages
- Medical care
- Education and communication
- Other groups and services
While it is the commonly used indicator of inflation, the CPI has come under scrutiny. For example, the CPI rose 1.4 percent between January 2020 and January 2021 – a relatively small increase. A closer look at the report, however, shows the movement in prices on various goods tells a different story. Used car and truck prices, for example, rose 10 percent during those 12 months.
Investments & Inflation
Inflation can affect investments in several ways. Most notably, it can reduce the rate of return, risk purchasing power, and influence the Federal Reserve.
Rate of Return
Inflation reduces the real rate of return on investments. Say an investment earned six percent over a 12-month period. During that time, let us say inflation averaged about 1.5 percent. That would mean that your investment’s real rate of return would have been 4.5 percent – not six percent. This makes it essential to consider inflation when developing your retirement plan.
Inflation also reinforces the power of investing. Keep your hard-earned money in cash will cause it to deteriorate in value year after year. Meanwhile, if you keep your money in a savings account, the same might be true if you earn less than 2% interest. While there’s benefit to maintaining liquidity for your retirement fund, holding excess cash on hand or in your savings account can cause you to lose money.
Inflation puts your purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer goods and services. As a result, you may need more money in retirement in order to finance the same lifestyle you are living today.
The Federal Reserve
In addition, inflation can influence the actions of the Federal Reserve. If they want to control inflation, the Federal Reserve has several ways in which it can reduce the amount of money in circulation. Hypothetically speaking, a smaller supply of money means less spending – which could equal lower prices and lower inflation.
With so many changes over the past year or so, it is no wonder investors and consumers are concerned about the rate of inflation today. When inflation is low, it is easy to overlook how rising prices are affecting a household budget. In addition, when inflation is high, it may be tempting to make changes to your financial standings and portfolio. If you are concerned about the inflation rates we are seeing in 2021, reach out to discuss if changes need to be made or if you and your portfolio are already well prepared.