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Inflation Primer

Since the fall of 2021, the US inflation rate as represented by the Consumer Price Index (“CPI”) has been steadily rising. The rate hit a high of 8.6% for the 12 months ending May 2022. This means, in May, prices were on average almost 9% higher than they were last May.  These levels are the highest seen in this country in 40 years. Many people thought inflation would pass in early 2022 as pandemic-related supply chain issues resolved, but inflation has persisted for a number of reasons.

What is behind this? More money and less goods. There was an enormous increase in the money supply during the pandemic with the government offering trillions of dollars in aid packages without a corresponding increase in production. This caused increased spending with more money chasing fewer goods and services which makes prices rise. Also, the pandemic created shortages in the work force which caused wages to increase, again, putting more money into the hands of consumers. In addition, the war in Ukraine has caused global shortages in energy and food which continue to drive prices up.

What can be done? Reduce the supply of money. The Federal Reserve regulates private banks and manages the supply of money. Its goal is to keep the inflation and employment rates stable. When inflation rises, the Federal Reserve can raise interest rates by setting the Fed Funds rate, which is a lending rate between banks. As rates rise, it becomes more expensive to borrow money for things such as homes and cars. People spend less, demand goes down for goods and services, and prices decline which curbs inflation. It is a delicate balance keeping prices in check while maintaining jobs and economic stability, and it takes time for the economy to adjust. The markets currently reflect the anticipation of several more interest rate hikes through the remainder of 2022, signifying the Fed’s commitment to controlling inflation. The Fed Funds rate has risen from 0.25% in January to 1.75% at the end of June. Consensus is that this rate will be in the range of 2.50% - 2.75% at the end of 2022.

What does it mean for me? Costs more to purchase the same amount of things and investment returns are dampened. The most obvious impact of inflation is reduced purchasing power – each dollar buys less goods and services. The basket of groceries you usually buy costs more and it is noticeably more expensive to fill your gas tank. In addition, real investment returns are tempered because of inflation. If investments returned 12% last year, and inflation was 8%, the real rate of return would have been 4%, not 12%. This has a negative impact on your long term retirement savings plan.

While we are still a ways from the inflation of the 1970s and early 1980s which averaged over 9% for a 9 year stretch, there are steps you can take to protect yourself against the effects of inflation.

  1. Have a plan for your cash needs. You should only hold in cash what you need to fund your cost of living, short term goals and an emergency fund (3-6 months of living expenses). When inflation is significantly higher than any rate on a bank account or money market fund, cash balances actually lose money from the erosion of purchasing power. Take a close look at your cash position with your financial advisor and be sure it is reasonable for your needs, and not excessive. Discuss alternative ways to deploy excess cash to meet long term financial goals.
  2.  Develop strategies for protecting long-term savings. More persistent inflation can pose a threat to your long-term financial plan. There has been much discussion lately about positioning portfolios to withstand inflation. Despite not always moving in tandem with inflation, stocks have consistently performed above inflation over longer periods which is the time frame for retirement assets. According to research done at Yale University, over a series of 30 year rolling periods in the last 140 years, the “real” returns on U.S. stocks have averaged around 6.5% (adjusted for inflation). So for long-term investment purposes, stocks are a solid choice to hold in your portfolio. Additionally, as interest rates rise, bond prices tend to fall. Here at Sandy Cove, we have repositioned our clients’ fixed income portfolios to the short end of the maturity spectrum to take advantage of reinvestment at potentially higher rates in the near future.
  3. Consider inflation hedging assets. There are specific assets which are touted as inflation hedging assets - gold, commodities, cryptocurrencies and real estate. Research has shown that gold, while once considered a good hedge against inflation, holds no real correlation to inflation and therefore does not provide protection from it. Commodities, as a class of assets, have low correlation to stocks and bonds (meaning, when stocks and bonds are faring poorly, commodities perform well, and vice versa). But as a general asset category, they are more volatile and risky than equity and debt securities. The data on cryptocurrencies is so new that its role as an inflation hedge at best is uncertain. And last, real estate does have data supporting outperformance in times of inflation. However, as with any asset category, there are tradeoffs to consider as real estate can be illiquid and expensive to buy. Here at Sandy Cove we believe in asset diversification, but not all assets are appropriate for your portfolio, so you should speak to your advisor about what is best for your situation.
  4. Pay extra attention to your expenses. No one likes to talk about budgeting. In a time of higher costs and an uncertain near term economic picture, it is worth looking at your expenses to see where “lifestyle creep” may have come in. This is a familiar pattern of spending more as you earn more money. The best defense against this is to set and review a monthly/annual budget. Look at your budget by category and see what may be contributing to higher recurring expenses. Obvious areas to address in an inflationary enviroment are: 1. Dining out, 2. Energy costs – think about when/where you drive, adjust thermostat and lights, 3. Review all mobile apps, subscriptions, memberships, 4. Check with cell phone and internet provider – often less expensive plans are available. These are all ways to pare back expenses in the near term and should be part of an annual review.
  5. Review homeowners policy to ensure adequate coverage. As inflation has driven up home prices and costs of remodeling, it is important to ensure that your homeowners policy accurately reflects the true replacement cost of your home. It is recommended that you carry insurance coverage equal to at least 80% of the home’s total replacement value. Check with your agent to be sure you have adequate protection.

While it is tempting to be concerned as you see the daily reporting of negative financial news, do not panic. Recency bias is the tendency to place greater importance on the news that is in front of you.  Be aware of this and know the reason you have a financial advisor and a plan in place so that you know where you are headed in times of uncertainty.