You may have heard the word inflation swirling around recently. It can sound like a scary word. But should we be concerned about it?
Read on for thoughts on understanding inflation and how it’s measured, as well as answers to some common questions to help clarify how inflation will affect you.
What is inflation?
One simple way to think of inflation is that each dollar in your wallet buys a little bit less.
Alternatively, you can think of it as a rise in the cost of items you buy.
It’s common for inflation to rise a little bit each year, in the 1 to 3 percent range.
Small, yearly increases in price are usually manageable. Businesses can adjust their product pricing and individuals can adjust their spending behaviors at a 2 percent annual inflation level without large disruptions to the economy.
However, large increases in inflation can be very disruptive to an economy, so this indicator is watched closely by investors and government officials.
How is inflation measured?
Inflation is measured by tracking changes in prices. Just like a grocery shopper might carefully watch price changes of items they regularly purchase, such as milk or eggs, the government tracks an imaginary “shopping basket” with different items in it; they call their basket the Consumer Price Index. This Index’s data is released monthly by the Bureau of Labor Statistics and measures an average change of prices for a defined group of consumer goods and services.
Can inflation ever be good?
Generally, it does not have a positive effect. However, small increments do not usually mean there is cause for long-term concern. In fact, in certain cases, this indicator can signal positive economic developments. For example, exiting the 2020 Covid-19 pandemic, the U.S. government’s inflation data started to show higher-than-normal readings. This is largely a consequence of the economy restarting after near shutdown. Supply chains must be restocked. Idle manufacturing machinery must be restarted to accommodate fresh product demand. This time lag between limited product supply and surging demand can cause temporary shortages, driving up prices for brief periods until suppliers catch up. Economists call this “transitory” inflation, meaning that it is unlikely to last.
Ideally, we should return to the long-run inflation rate of ~2 percent over time.
How does inflation affect my investments?
History has taught us that proper diversification across different asset classes is very important, especially during inflationary environments.
Investors often look for ways to avoid inflation’s effects by buying things they hope will increase in value during inflationary periods. Some investors use stocks, which have historically performed well in inflationary environments.
Investments with regular cash flows, like bonds, are sometimes challenged during inflationary periods. Investors often prefer the certainty of value now instead of the uncertain value of future cash flows.
This type of complexity with diversification, research, and portfolio balance is best managed with the help of a qualified financial advisor.
What if I am on a fixed income? Should I be worried about inflation?
Fixed income may be challenged during inflationary periods; however, there are ways to diversify fixed income to have exposure to areas less impacted by inflation. The best way to avoid potential problems is to talk to a financial advisor who can help you minimize this risk by using a properly diversified portfolio. An independent, fee-only financial advisor will be able to do so without offering you proprietary products they receive commission on, or without being tied to certain types of account management techniques.
How long should I expect inflation to rise? Is it permanent?
It is unclear how long the current inflationary environment could persist. The Federal Reserve (known as ‘the Fed’), a government body responsible for promoting stable prices across the economy, has several tools in its toolbox to combat inflation.
One tool is the ability to change lending rates. This can discourage bank borrowing and slow the pace of spending and, therefore, inflation. Another tool the Fed uses is direct market intervention, which consists of buying assets to keep interest rates low. These tools, and others, give the Fed the ability to respond quickly to contain runaway inflation. Persistent inflation much above historical levels seems unlikely at this point.
Conclusion
Inflation is only scary if you do not have a plan. Fortunately, Domani has deep expertise and experience in navigating many market environments, including inflationary ones. The best strategy for any investor is a diversified one that can help you reach your financial goals, whatever the inflationary environment.
If you have questions about your portfolio with us or have a loved one who may have questions and need advice, we’re always happy to have a conversation. You can get in touch with your advisor anytime, and refer a friend or family member directly to us!
