How might inflation affect your financial plan — and your portfolio — today?

There has been a lot of talk about inflation recently. Companies mentioned inflation a record number of times in their latest quarterly earnings calls with investors^[1], it is a hot topic in the media, and consumers are feeling its impact at the grocery store. In this conversation with members of BDO Wealth Advisors’ investment and wealth management teams, we define inflation and discuss what it means for investors today.

 

How do you define inflation? How do you measure it?

In a general sense, inflation is an increase in the prices of goods and services that causes a decrease in purchasing power. Beyond that, it is useful to understand a few things about the inflation numbers quoted in the media. First, there are a variety of ways to measure inflation. The most commonly cited measure is the Consumer Price Index (CPI), which is defined as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services,” according to the U.S. Bureau of Labor Statistics. But other inflation measures are available, such as the Personal Consumption Expenditures Index (PCE), which is favored by the U.S. Federal Reserve (the “Fed”). The basic difference between the CPI and PCE is that the CPI is based on a survey of what households are buying, while the PCE is based on surveys of what businesses are selling.

 

Is inflation a good thing or a bad thing for the economy?

Many people don’t understand that a small amount of inflation is good, and that persistent negative inflation (falling prices) — also known as “deflation” — can be disastrous. The Fed wants to keep long-term inflation at about 2%. That gives consumers an incentive to buy things today rather than waiting a year or so, which keeps the economy’s engines running at a steady pace without causing panicked buying. With deflation, consumers expect prices to be lower a year from now, so they delay purchases. That depresses demand, which causes manufacturers to produce less, leading to higher levels of unemployment that lowers discretionary income, which further reduces spending … and the economy goes into a downward spiral. So, while excessive inflation is undesirable, a stable, low rate of inflation is generally helpful for the economy.

 

The word “transitory” has been used a lot lately. Is the higher inflation seen recently just a temporary blip that will revert back to “normal”?

It all depends on how you define the word “transitory.” For example, consider the recent run-up in used car prices due to the global semi-conductor shortage that has limited the supply of new cars. That price increase is temporary — in fact, used car prices are already starting to normalize. Full normalization of new car inventory may take a longer time, but over the long run, the spike in used car prices likely won’t last. But consider another example: If restaurant wages increased from $12/hour to $15/hour to attract more workers, that increase would probably be stickier and therefore less likely to be transitory. Even in this situation, however, the increase is less likely to be repeated in the coming years as the employment landscape normalizes.

In sum, while we don’t expect the high rate of inflation seen in recent months to persist, inflation could remain elevated in the near term and even the intermediate term.

 

What are some common questions you’re receiving from clients about inflation?

Historically, inflation is not something many clients spend a lot of time thinking about. Stable prices in the U.S. have been a basic assumption for many years. Recently, we have seen more interest in inflation, and factors like rising prices at the grocery store have helped to raise awareness. Even assuming inflation is not a long-term concern, clients may overlook the impact that inflation has on the value of their cash. Clients often hold more cash than needed.  Even if you assume modest inflation of 2% — the Fed’s inflation target — cash earns roughly 0% interest, guaranteeing a negative return after inflation. In that sense, cash is your enemy. Of course, an individual’s time horizon always matters. If you know you’ll need a certain amount of money over the next 12 months or so, you should hold some cash.

Some clients have asked about the level of government spending we are seeing and whether that will cause higher inflation. To do this topic justice would require its own article, but in short, the fact that the government is “printing money” is not necessarily inflationary. Supply chain disruptions, on the other hand, are much more impactful on inflation. They have severely reduced what is available to buy — from cars to lawn mowers to toys — and demand has increased as consumers generally have more discretionary income than before the pandemic. All of this has caused a classic supply/demand imbalance that is likely to take another six to 12 months to resolve itself.

 

What advice do you have for clients who are worried about inflation and how it may affect retirement savings and other financial goals?

If you are worried about inflation, have a conversation with your financial advisor! Before you make any significant decisions regarding your portfolio, your savings, or any aspect of your financial life, speak with your advisor to get a better understanding of your financial plan and where you stand today. Modeling various inflation rates from a long-term planning perspective is an essential part of the process.

When you have a well-defined financial plan and a well-diversified portfolio, often the best thing you can do is to avoid having any knee-jerk reactions and acting too quickly. Instead, allow your financial plan to do what it is designed to do. As long as you live within your means, a solid financial plan should do the job for you.

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[1] https://www.marketwatch.com/story/heres-how-often-inflation-is-being-mentioned-on-corporate-earnings-calls-11627932513