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Inflation Considerations

Posted on Thursday, January 27, 2022

Losing your money safely! That’s what we say about stuffing your mattress or hoarding cash in a bank account with little or no opportunity to grow. With current inflation around 7%, it means that the $100 bill you buried in the back yard is only worth $93… wait… what? It’s still $100!? To review, inflation is what happens when the value of hard-earned dollars are worth less in terms of buying power. Fortunately, we always plan for inflation; it’s a primary reason to invest in almost every financial plan.

Is inflation ‘bad?’ Is inflation ‘normal?’ And, what should you do about it?? With all of the doomsday headlines about 2021 inflation rising to 7%, it’s important to consider some historical perspective. Consider the following points:

• While 7% inflation is on the high side, it’s still within the normal range. The average inflation rate from 1960 through 2019 was 3.68%, and the standard deviation was 2.77%. During the same period, the range was 13.9%, meaning peak inflation for the U.S. was 17.58%. As all of our fellow nerds will confirm, it’s expected that 68% of data-points will land within one standard deviation of the average. We are a little above that mark for 2021. Concerning, but certainly within the realm of possibility especially considering the supply and demand imbalance caused by the 2020 covid recession.

• Peak inflation during the 1980s led to a modernized approach at the Federal Reserve. With inflation hitting a high of 17.58%, then chairman, Paul Volcker, drove a revamped approach to the Federal Reserve’s policies in order to fight this astronomical rate. Historically, policies focused on full employment, often letting rising inflation rates run to ensure unemployment stayed low. Volcker adopted an approach based on monetary theory—that prices are not tied only to wages, but also supply and demand. Low supply, high demand, higher prices. Think oil in the 80’s... Toilet paper in 2020... And, cars in 2021.

• And… the new approach worked. Really well! Frankly, the Federal Reserve has done a great job managing inflation. Since 1990, we’ve been spoiled with a below average rate at just 2.3%. The ‘high’ inflation years averaged only 2.98%, still below the average dating back to 1960. While inflation is driven by multiple factors, the Fed deserves much of the credit.

• Not all inflation is created equal, even in 2021. Oil, energy, and vehicles were the most significant contributors to the 7% rate. In October and November, oil and energy increased by about 50% and 33%, respectively, year-over-year, each month. This minimal list far outweighed much more moderate rates of inflation which were more broadly applicable among other inputs. Surprisingly, even healthcare, one segment which is historically higher than the average, was down in the months ending 2021.

News flash! 2020 and 2021 were weird years, to say the least. Covid spawned a supply-side, event-driven recession. To flatten the curve while the healthcare industry developed treatments vaccines, supply of goods was choked off. However, demand didn’t just disappear. In fact, it increased with pent-up demand! Durable good purchases in the U.S. increased by a factor of 5 when comparing the 18 months before the pandemic to the 18 months after its start. When supply is low and demand is high, prices go up. Most recessions are demand-driven, rather than supply oriented, so the rebound drove higher inflation than usual.

Understanding that low supply has been a major factor in the high inflation rate, the question on everyone’s mind is if it’s a transitory phenomenon that will resolve as supply resolves. Of course, no macro-economic drivers are that simple. We expect that some segments will settle while others linger at a higher rate. How long? We don’t know. If we had that crystal ball, we’d own Patagonia by now. A reasonable outcome is that the Federal Reserve allows inflation to run above its 2% target for a while, perhaps to a 3% target. But, since the 1980’s, the Fed has shown it will act swiftly and decisively to keep inflation in check. This is not the first time our country is dealing with increasing inflation rates! For you and your family, what to do about it starts with your plan. We have always considered inflation as an external threat, even planning for expenses such as college and healthcare with a higher rate of inflation than broader plan expenses. So, stay focused on what you can control, and have confidence knowing that our recommendations already incorporate high degrees of variability in inflation—mattresses have many good uses, but a savings strategy is not one!

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