YOUR GUIDE TO INFLATION: THE GOOD, THE BAD, AND 3 WAYS TO HELP FIGHT IT
With the news this past Friday that the US Inflation rate hit a 39-year high of 6.8% in November[1], we should talk about inflation. It’s a word that you’ll hear on the news or read online almost daily when the subject of the economy or the Federal reserve comes up and is thrown about in numerous conversations related to finances.
It’s probably one of those words that you think you know what it means, but if someone asked you to define it, you’d probably draw a blank. Whether you understand inflation or not, unfortunately, one of the only things deflationary in 2021 has been the Miami Dolphins!
Luckily, those of us who aren’t Dolphin’s fans aren’t affected by this, but we are all subject to the ebbs and flows of inflation. That may leave you wondering what inflation actually is, how it works, and how it affects you?
Well, we believe you’ve come to the right place. So, enough about the Dolphins. Here is what we think you should know about inflation.
What is Inflation
When someone talks about a cup of coffee that used to cost 25 cents, and now it's closer to $2, this is inflation. In short, inflation is the increase in the price of a good or service over time. Essentially, the purchasing power of a dollar for consumers decreases because the general price of products or services tends to increase over time.
As we are a consumption-based economy, that is our economy is based on a steady level of people buying goods and services, inflation is influenced by consumer activity and the availability and supply of money. For example, if the government announced today that they were going to print $1m worth of new bills, this would cause the supply of money to rise, making the dollar less valuable, which would cause a rise in prices. The dollar you had today would buy less than the dollar you have tomorrow. And, what actually has happened is that since the start of the COVID-19 Pandemic, the M2 money supply has grown by 37% from February 2020 through October 2021 to $21.2 trillion in circulation. [2]
The most common tracker, or index, that shows the rate of inflation is known as the Consumer Price Index (CPI). This measures the prices over time of a basket of goods and services, anything from food to electricity, to clothing and cars, that consumers would utilize to live their lives.
There are two important variations of the CPI, there is CPI and what is known as “Core CPI” which is the consumer prices index measuring all items less food and energy. It’s important to understand the difference between the two as the prices of food and energy tend to be far more volatile than other goods and services as they are highly affected by the basic economics of supply and demand (i.e. they are commodities).
For example, think of meat in grocery stores. You want to buy meat to feed your family, and you decide that steak will be on the menu this week. However, when you arrive at the supermarket, the price of steak has gone up due to a lack of supply, so it is no longer within your budget. You still need meat, so you’ll find a substitute - such as chicken, lamb, or a meat-free substitute. As the supply of steak catches up over the following week, the price will decrease to drive purchases once more.
Energy is similar - if the price of your supplier gets too high, you’ll search for a cheaper provider as you still need to turn your lights on, heat your house, or drive your car. Plus, the suppliers will produce more energy since prices are higher. Both factors subsequently drive down prices.
This is what causes prices to fluctuate on these two commodities so much and to be viewed separately from other goods in the CPI.
Other goods and services, however, aren’t typically subject to the same volatility. Take Apple for example, and the historical rate of inflation (2-3%). If the price of an iPhone increases by 2-3%, are you going to suddenly ditch Apple and change your smartphone? Probably not - you still need your phone.
So, is inflation good or is it bad? Not to dodge the question, but the truth is both.
How can this be, I hear you ask? Let’s find out!
When Inflation is Good
The basic premise of why inflation is good comes back to one of the facts I mentioned earlier - that the U.S is a consumption-based economy. Historically, the yearly inflation rate has ranged between roughly 2-3% over time[3]. These are steady and almost unnoticeable in the short term and are what the Fed looks to target to achieve each year.
The government wants some degree of inflation as it pushes people to consume more. Think about it, if you are thinking of purchasing an item - are you likely to buy it when it’s cheaper or more expensive? I think it’s safe to assume the former. So, having a steady increase encourages people to buy things now instead of waiting to avoid buying the same item at a higher price.
Plus, the more we spend, the more money governments generate through sales and business taxes. This is why governments try to incentivize consumption as best they can because consumption begets more consumption, and continues to drive the economy.
What the government tries to avoid is deflation, which is the decrease in prices. If prices decrease, people will hold off on making purchases to try to get what they want as cheap as possible. This will lead to a decrease in consumption, a decrease in tax revenue by governments. In an effort to recover the loss of revenue, governments may increase taxes, which causes a further decrease in consumption as people try to maintain their lifestyles. A vicious cycle!
This is why maintaining a steady level of inflation is both good and important. However, this increase can sometimes get out of hand. The last time inflation was above normalized levels was during the 70s and early 80s.
If you haven’t heard, similar spiking has started to happen again.
When Inflation is Bad
One of the main reasons we’re currently experiencing a spike in the inflation rate is due to an effect known as cost-push inflation. Cost-push happens when a rise in production costs increases prices, which can happen due to a number of factors. Currently, it’s being caused by supply disruptions.
This increase in prices is what can lead to the negative impact of inflation. If prices become too high, it hurts consumption and people’s purchasing power, ultimately - people will be unable to maintain their current lifestyle.
This can hurt both the consumer and businesses. If people can no longer afford the products and services they need, they can no longer maintain their same lifestyle and businesses may struggle to keep their doors open. A knock on effect may be for employees to seek to move to a new company or demand raises to combat the cost increases in their lives. This then hurts businesses who lose key employees and/or effect their profits. While this can be ok in the short-term, if this is persistent, disruption in both consumers and businesses can have a negative overall impact on the economy.
Eventually, to help combat this, the Fed may seek to raise interest rates and reduce the supply of money - what’s known as tightening monetary policy. Essentially this is reducing the amount of money to go around, to help cause inflation to drop to a steadier level.
It isn’t just governments that do this though. The energy sector is a prime example of this, being one of the biggest commodities at play in inflation. When I was an equity research analyst covering the energy industry, there was a saying I constantly heard from the CEOs of energy companies, “The cure for high prices is high prices, and the cure for low prices is low prices.”
As we touched on earlier, being a commodity, energy works on the basic forms of supply and demand. If there is a high price of energy, companies may increase their output (supply), which without a subsequent increase in demand, prices drop. On the flip side, if prices drop too low, companies may produce less, and without the subsequent decrease in demand, prices will rise. For basic commodity goods and services, the laws of supply and demand will ultimately play out until price equilibrium is found[4].
Consumers do this too. During the peak of COVID, for example, it cost me just $30 to fill up my tank. Now, it costs about $60. This may cause me to change my driving habits, like driving less or carpooling, for example, to reduce the impact of the price increase.
Another example would be with food. Recently my wife and I went out for dinner, and my wife ordered chicken. The same meal would have cost 50% less if I made her chicken at home. So, next time we wanted chicken, we grilled it on my home grill. Same enjoyment for half the price!
In essence, people, businesses, and governments, all take action to combat the effects of inflation. So, how do you do this for your personal wealth?
3 WAYS TO HELP COMBAT INFLATION
1. Rethink your Portfolio Allocation
In a world of inflation, like ours, relying solely on a fixed income or cash is a tough proposition. We’ve heard the old “money under the mattress story” - someone puts money under their mattress in case of an emergency.
For the sake of this example, let’s say you put $1,000 under your mattress and leave it there for 1 year. This cash earns 0% interest (doesn’t increase in value). If inflation goes up by 6% over that 1 year, you’re earning -6% in that $1,000. So when you pull it out from under your mattress, you won’t have $1,000 anymore. You’ll only have $940 of current purchasing power.
If you do this for 10 years at the same 6% inflation rate we are currently experiencing, your purchasing power will be reduced by about 54%! Said another way, that same $1,000 today would have the purchasing power of about $540 ten years from now!
The same can be said of owning treasury bonds. Currently, the 10-year treasury interest rate is hovering around 1.5%. Even if inflation stays at just 3%, you’re earning -1.5% in real terms (interest rate minus inflation rate = real return).
Many people will say that you need a balance of 60% equities and 40% fixed income - but this is a flawed approach in my opinion. You should seek to tie your cash to your immediate spending needs, and the amount you need for psychological safety. Last-minute spending and expenses always have a way of turning up and you need to be able to adjust to this.
Then seek to construct a portfolio for your medium and long-term that properly adjusts to the current realities of interest rates. This can potentially mean a portfolio that has far less fixed income than has been the traditional norm.
2. Seek to Own High Quality, Profitable Businesses
Let’s return to our earlier example of consumer behavior - the restaurant. If this restaurant’s prices become too high, people will stop eating here and this business will begin to lose money. Other businesses, however, won’t be subject to the same issues, as they have what is called pricing elasticity.
Pricing elasticity means that a business has the ability to raise its prices without impacting its profits because the demand for its products or services are so strong. These companies have some sort of “moat” around their business with high barriers to entry. This gives them the luxury to push price increases they are seeing from inflation back onto their consumers, rather than weathering the storm themselves.
If the price of Apple’s iPhone goes up, for example by 6%, are people really going to stop buying iPhones?
If the price of Nike’s went by the same amount - are people really going to switch to another brand? After all, you can’t not wear shoes, and especially if you’re training, you’re going to want the best.
If Abbvie, a pharmaceutical company, increased their prices by 6% and they made the medicine you need for your health - are you really going to stop buying it?
These are just some examples of the types of high-quality businesses that you could seek to own. They are high-quality businesses as measured by having high returns on equity. They have some form of barrier to entry, and they can seek to push price increases back onto their consumers without affecting their profitability over the medium to long term.
3. Understand Inflation in Context
If you hear that inflation is spiking, should you panic? No. In essence, don’t let your emotions be your enemy. As we have discussed in the past, our own emotions can be our worst enemy when it comes to building sustainable wealth. Inflation numbers have been fairly tame post the 70s, which I am sad to inform some of you that was over 40 years ago.
In the last two years, we’ve experienced unprecedented times, which have caused events and economic events of a similar nature. However, things should start to stabilize as the market as a whole tends to correct itself. When prices get too high, we adjust. When prices get too low, we adjust.
This is the importance of behavioral coaching. It helps you step back, cut out the short term noise, and see the bigger picture.
Conclusion
Inflation, like most things, can have good qualities and bad. Without the proper knowledge, and the appropriate action, inflation will eat away at your spending power, or limit your future potential. Just like that cash under the mattress.
Seek to get on the right path that will in fact allow for the opposite to happen. That is, for your money to grow, maintain purchasing power, and set up the security of your financial future.
Have more questions about this topic? Feel free to schedule time to speak with us today.
References:
U.S. INFLATION HIT A 39-YEAR HIGH IN NOVEMBER - WSJ, NOVEMBER 2021
Board of Governors of the Federal Reserve System (US), M2 [M2SL], retrieved from FRED, Federal Reserve Bank of St. Louis;https://fred.stlouisfed.org/series/M2SL , December 6, 2021.
The Bureau of Labor Statistics;https://data.bls.gov/timeseries/CUUR0000SA0L1E?output_view=pct_12mths, retrieved on December 7, 2021.
Law of Supply and Demand - Jason Fernando, Investopedia, November 2021.
What is the average interest rate for savings accounts? - Matthew Goldberg, Bankrate, November 2021.
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