If you are under 45 and live in America or Europe, the odds are this past year has been your first real experience with inflation. Other than a blip in 2008, inflation has barely topped 3% in the last 30 years.
But now inflation is back; up more than 8% last month, and it may get worse before it gets better. Some of the drivers of price increases today, supply chain disruptions and war in Ukraine, will eventually abate. But there are reasons to believe we aren’t going back to 2% inflation anymore. The economy is different and the new baseline for inflation will be 4% or 5%.
Americans used to get along just fine when higher inflation was the norm. But the world is different now; 4% poses new costs and benefits to a new generation.
So what does it mean for living your life or conducting your business if inflation hovers between 4% and 5% instead of the 1.5% to 2.5% we've taken for granted for so long? To paint that picture, we need to assume a reasonable degree of stability. If inflation is higher, but remains in a tight range, it won't cause too much damage. The average inflation rate was 4% or 5% for many years and the economy still grew.
That said, much has changed since the late 1980s when inflation hovered around 4%. That rate is almost twice what people now are used to, and all segments of the economy will have to adapt. Getting a pay raise was less critical when inflation was 1% or 2%. Employers got used to giving smaller increases. The last time inflation was high, unions negotiated annual cost-of-living raises built into the pay of many workers. Now most will need to demand it for themselves. For workers who don't — or can't — negotiate raises that keep pace with inflation, their real compensation will shrink each year as their pay is worth less. Even if you do get a decent raise, those increases generally come just once a year, while inflation happens continuously, eating away at your buying power.
Companies won't get off easy either. They'll face higher costs for labor, rent and the goods they use. They will need to increase their prices more frequently, which risks alienating their customers. It puts smaller firms at a disadvantage, shifting demand to large companies with fatter profit margins that can afford to absorb some of the inflation so that they pass on less of the pain to the consumer.
Inflation will be a bigger problem for small business than it was in the 1980s because big firms dominate the market now — odds are your local mom-and-pop hardware store is already barely hanging on against Home Depot. The online marketplace that brought prices down by increasing transparency will continue to make it harder to raise prices above competitors, which will be another strike against small companies.
Interest rates will go up because the Fed will raise rates to keep inflation in check, and investors will demand higher rates to compensate for inflation. That will mean more expensive mortgage loans. That would usually weaken housing prices, but as long as demand outpaces supply — which we're seeing now — and if the rental market continues to go up, you can’t count on housing prices falling. However, if you already own a home with a fixed-rate mortgage, your wages will go up, while your monthly mortgage payment will stay the same, meaning your real housing costs will fall (though not your property taxes or upkeep costs).
Nest Egg Strategy
Saving and investing will also be more challenging. Right now, banks are paying basically about zero interest on your savings. If inflation increases, they will pay a little more interest, but don’t expect the 8% rates paid on certificates of deposit in the 1980s. Banks have less need for retail banking than they did in the 1980s, so odds are they will be less inclined to increase rates to woo customers to open accounts.
Government bonds offer another low-risk investment option, and those rates will increase, too. But they may not increase enough to compensate for inflation because, compared with the 1980s, safe assets are still in hot demand by foreign governments and banks for regulatory reasons. So if you want to protect your savings from getting eaten away by inflation, you’ll need to invest in riskier assets.
And if you are being pushed into riskier assets, diversification will be key. Holding many stocks reduces your risk without lowering your expected return. The easiest and cheapest way to gain risk exposure and diversification is to buy a simple, broad stock index fund, such as the S&P 500. Or if you want even more diversification, choose a global stock fund. These investments are a good hedge for inflation, are well diversified, and very liquid so you can sell them if you need cash.
If you desire more risk and more diversification you can include a commodity fund or a bond fund that includes corporate or municipal bonds. The key is to find funds that charge low fees, are liquid, and include as many different securities as possible. Real estate is also considered a good inflation hedge, but it's less liquid and has higher fees, so it's less advisable unless you plan to own it for a long time.
Retirees are normally the most harmed by inflation because they live on a fixed income. The good news is Social Security is indexed to inflation. But when inflation was low, some pension plans cut back on their cost-of-living adjustments, which didn't seem like a big deal at the time. With inflation at 4% or 5%, though, retirees will notice. Those with 401(k)s or IRAs are normally encouraged to invest in short-term government bonds as they age to protect against market risk. But if these bonds don’t keep up with inflation — and they probably won't — people will feel pressured to keep more of their nest egg in risky assets. That could make their income, and spending ability, much less predictable.
Debt’s Silver Lining
Higher inflation will have some benefits, especially if you have more debt than savings, as your income should rise while the amount of your borrowings stays the same, so you have more money to make payments or pay it off altogether. This will be a boon to student debt holders and homeowners with fixed-rate mortgages.
So if we do get to that place of higher, but stable, inflation, Americans will probably have an uncomfortable period of adjustment learning to live with rising prices at the grocery store, in restaurants, and everywhere else we’ve become accustomed to stable costs of living. But our economy and personal finances will adapt as price increases flow through and wages follow. While 4% inflation isn't what it used to be, this is a new economy and we'll all need to adjust how we invest and develop a strategy to defend against inflation. Certainly, though, it will be a long time before anyone again feels complacent about inflation.
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