Should you be worried about inflation?

 [Ed. Note: This is a two-part post on inflation and your financial plan. Each will be slightly longer than usual because inflation is a complex topic. My blogs attempt to make the complex accessible, but not at the expense of accuracy. Please send me feedback and questions.] 

Another month, another multi-decade high in inflation numbers. Inflation was 7% annualized in December 2021, a 39 year quarterly high. The US rate will probably be nearly 5% for 2021 which is the highest since 1982. It hasn’t been over 4% since 1991 and in the 30 years since then has averaged (arithmetic) 2.33%.    

Yes, it’s difficult to calculate inflation in the economy, and the CPI is very imperfect. There are potential biases in both directions.  Still, it’s incredible that the inflation rate was so low for so long. Just 18 months ago in the middle of the pandemic the Federal Reserve made a change to it’s target of 2% inflation to see 2% as an average rather than a ceiling. They were worried that long term inflation was too low. (Modest inflation is always good.) 

Inflation worry is everywhere; 88% of Americans are concerned about inflation (Oct 2021). Google searches for inflation are more than double than the ten years prior to 2020. If you are buying meat, a car, or a hotel room you have seen prices increase by over 25% on average. Gasoline is up 50%. Should you be worried? 

How serious is the risk of sustained inflation? That’s hotly debated and, like everything in the USA right now, it has become political. But unlike climate scientists, the best dismal scientists disagree about whether inflation is transitory or not. We don’t really know. But let’s assume we get a solid bout of inflation for a while. 

Who really suffers in an inflationary environment? Globally, at least, inflation affects the poor the most in both the short and long run. Their actual experienced inflation is higher than the national average. That could make the wealth gap worse. It’s absolutely more stressful and debilitating to the low and moderate-income population simply because they have so little room for change or error in the budget. So yes, they should worry, and they do. 

The second most vulnerable group is retirees and near retirees. A paper from Alliance-Bernstein showed that retirees face more inflation risk. Social Security keeps up some with inflation but isn’t perfect. Bonds and stocks are lousy against inflation in the short run (more on that in part 2). They frequently are on very fixed budgets and can’t easily adapt to changes in prices, causing stress.   

Younger investors, especially those with higher wages, are in good shape for three reasons and generally do not need to worry about inflations impact on their retirement: 

 
1) Wages match inflation over time: In your working years wages tend to increase over time with - or exceeding - the inflation of your expenses. The correlation is not perfect but it’s been a pretty good bet historically. If you are in a professional industry, wages have likely exceeded inflation. 

2) Real Estate and mortgages: A pre-retirement worker may own real estate (there was a 65% homeownership rate in in America 2020) and have a mortgage. Although consumer real estate itself is not fantastic in an inflationary environment, the fixed-rate mortgage you pay the bank is getting cheaper. Few of us realize that at current inflation and mortgage rates, the bank is paying you to own your home in real terms. Inflation protection is another good reason to own a home. 

3) Stocks probably outrun inflation: In the pre-retirement ‘accumulation phase’ the average investor will own a lot (more than 60%) of equities/stocks in their retirement portfolio. Equities and stocks do badly when inflation hits, but they do very well over longer periods of time and eventually they make up for those losses to inflation. It’s technically not a hedge, you are simply outrunning inflation with solid market returns.     

If a young investor has large accumulated savings for a short term purchase (3-7 years) like a home down payment or renovation funds, they could consider using a short-term Treasury Inflation Protected Securities (TIPS) ETF to store it. TIPS have some downsides but might be the right choice.  
 
And watch your life insurance amounts because term life insurance values are eroded by inflation. Other than that, let your mortgage, your human capital (wages), and your stocks do the work for you.  

 One reason you shouldn’t be worried is your own perception of inflation. A paper by Ulrike Malmendier and Stefan Nagel points out that individual perspective on inflation is highly correlated with their historical experience with inflation. If your age cohort experienced a lot of inflation, you were more likely to anticipate it in the future. (This is true even among economists, who should know better, says a later paper.) Consumers regularly overestimate inflation. And it’s worse if you shop a lot because frequent exposure to price changes, even small ones, makes us overestimate real inflation. 

I’m by no means dismissing inflation concerns. But at a minimum, we should not let our biases drive financial decisions. No one knows where inflation is headed and for how long. Does that mean the rest of us should stop worrying? And how can retirees protect themselves from the impact of inflation on purchasing power?  What should retired investors do? Aren’t there ‘hedges’ one can buy to combat inflation? Commodities? Gold? Bitcoin? Art? We will look at the latest academic research in part two, same time, same channel.