Should I be Concerned About Inflation?

By GARY LISKA | Special to the Palisadian-Post

Over the past two decades, inflation has been climbing at a 2.1% average annual rate—markedly lower than the historic 3.2% average rate of inflation.

It now appears, however, inflation has finally returned thanks to a combination of factors, including more than a decade of “loose” monetary policy on the part of the Federal Reserve, a ballooning federal deficit and debt, and an unprecedented surge in post-quarantine consumer demand.

The July Consumer Price Index came in unexpectedly high—showing a 5.4% rate of inflation over the previous 12 months. And while the August reading ticked down a bit to 5.3% (below analyst expectations), it remains a cause for concern.

Other economic indicators show additional cause for concern:

Wages at the lower end of the wage spectrum have been rising at their fastest rate in more than a decade.

The Producer Price Index (PPI), which tracks the selling prices received by U.S. goods and services producers, is up 8.3% over the past year.

Home prices are up 19.1% over the past year (the largest annual gain since tracking began in 1987).

Global shipping costs have skyrocketed—with Asia to U.S. ocean shipping rates five times higher than they were a year ago.

The key question that needs to be asked is whether the recent inflation surge is transitory (merely a post-pandemic anomaly) or something more persistent that may be with us for a while? The Federal Reserve has voiced a strong belief that these current pressures are a short-term phenomenon and should begin to wane. But a number of regional Fed presidents are beginning to voice concerns about taking too dovish a stance toward the current rate of inflation.

But perhaps a more important question to examine is how might an extended period of higher inflation impact your financial plan?

How Inflation Impacts You

To some degree, everyone is adversely affected by inflation as the cost of goods and services rise. But it’s especially harmful to retirees who have to face higher prices without the benefit of a corresponding increase in working wages to help keep pace.

Inflation eats into the value of your assets. Even low levels of inflation can have a significant long-term impact on your finances.

Let’s assume you retire today with a projected $50,000 annual cost of living. Factoring in even a relatively modest 3% rate of inflation, that same lifestyle will require $90,000 per year to fund 20 years down the road. And the challenges are exacerbated when your portfolio is focused predominantly on liquidity and income-generating assets.

Most savings accounts and CDs today offer less than a 1% APR. Longer-term government bond yields are averaging between 1 to 1.5%, and even high-quality corporate bonds are yielding less than 2% on average. Given the current low interest rate environment, finding income investments that can provide the necessary rate of return to keep up with inflation often requires taking on far greater credit quality risk.

Even Treasury Inflation-Protected Securities (TIPS)—which are specifically designed to offer protection from inflation with minimal risk—are at best a stop-gap measure that’s unlikely to offer much if any growth potential over the long term.

On the plus side, higher inflation typically leads to higher interest rates—which down the road should make traditional bonds a significantly more attractive investment than they are today.

Stay Diversified

What’s the most effective way to fight inflation? Diversify your portfolio with a healthy allocation to stocks (or equity-based ETFs/funds) and real estate. That’s because equities and real estate are two major asset classes that have consistently outpaced inflation during every rolling 20-year period since 1926.

Even if you’re nearing retirement or already retired, it can be a serious mistake to completely shy away from stocks. At some point over the years, you probably heard someone advise that the closer you get to retirement, the more of your assets you should shift into bonds and cash to protect against stock market volatility. But that advice was from a time when retirements lasted on average about 10 years, most retirees had healthy guaranteed pensions and interest rates were significantly higher.

Nowadays, retirement can last 30 years or longer. Your portfolio not only needs to generate income, but also to continue to grow so it can provide income a decade or two down the road. Ultimately, your best way to protect your savings from being eroded by inflation is to maintain a well-balanced portfolio with a sizable, well-diversified stock allocation that offers significant growth potential in the years ahead. And make sure you and your advisor periodically rebalance your portfolio to maintain an appropriate level of risk.

Gary K. Liska may be reached at 310-712-2323 or seia.com.