What causes them, and how could they affect my portfolio?
The nation is currently grappling with record-breaking inflation. In 2021, inflation was about 7%—the highest it’s been since 1982.
From gas prices, to airline tickets, to our utility bills, we have seen price increases across the board. Prices for meat products and eggs rose around 12.5% for the year. Energy prices increased by an average of 59%. Used and new cars also rose by almost 40%. Many financial professionals feel that it’s safe to say the inflation we are facing is no longer a minor transitory issue. As we wrestle with this problem, it is essential to recognize why we are in a period of high inflation and what it means for our portfolios.
The “why” and the “what” are two key points that help us anticipate periods of high inflation and prepare us mentally when we are forced to dip a little more into our portfolio during these high inflationary periods.
Why do we have such high inflation?
This is a complicated question. Labor shortages, supply chain issues, and scarcity have affected inflation this past year. In addition, fiscal policy can affect inflation. Another big player is the Federal Reserve. Two of the Federal Reserve’s most significant responsibilities are to manage inflation and unemployment—both being inversely related.
The Fed does this through monetary policy. At the start of 2020, COVID-19 began to ravage the world. Government restrictions forced many businesses to close down, causing the beginnings of a recession. The federal reserve instituted an expansionary monetary policy in response to the signs that a recession was imminent. They began to lower interest rates by increasing the money supply by buying bonds. This type of economic interference helps the economy recover from recessionary periods.
Interest rates were brought down to practically zero and were held there for more than a year. The purpose of low-interest rates is partly to incentivize economic investment activity such as business expansion and projects. Low-interest rates mean low borrowing costs.
With lower rates and an increased money supply, inflation begins to increase. However, it takes time before we start to feel its ripples. We have been feeling those ripples since early 2020 and still feel them nearly two years later. Recently, the Fed announced that they would begin to taper bond buying, which will help ease inflation. Unfortunately, many financial professionals feel the Fed’s timing is overdue.
The Federal Reserve will likely begin to institute some contractionary monetary policy in the coming months. We may start to see inflation go down, interest rates rise, and unemployment increase. It almost feels like a game of teeter-totter, but it becomes easier to brace for future implications of any monetary policy once you see the patterns.
What can inflation mean for your portfolio?
One of the biggest concerns during periods of high inflation is how it will affect your portfolio as your purchasing power decreases.
Those who rely heavily on Social Security are especially vulnerable to sudden increases in prices. The Cost-of-Living Adjustment (COLA) for 2022 was 5.9%. The COLA increase has a shortfall of about 1.1% compared to the actual inflation increase of 2021.
Where retirees fall short in Social Security, they make up for it from other sources. High periods of inflation mean that retirees are eating through their savings at a higher rate than what was previously expected.
Those who rely solely on Social Security can only cut spending to remedy the shortfall. What’s the good news? Inflation of 7% is likely not permanent. In his most recent address, Federal Reserve Chairman Jerome Powell announced a tighter monetary policy regarding inflation. The Fed announced it would stop buying bonds altogether in March, and interest rates should also rise.
Portfolios will be subject to stress from time to time, and inflation won’t be the only one at fault. Fiduciaries anticipate such tensions and build those probabilities into the success of a financial plan. If you are concerned about how high inflation might affect your portfolio, consider seeking professional help.
We will likely pass through many different recessionary and expansionary periods in the years to come. Since the great depression, the US has dealt with 14 different recessions. In between, there have been many more minor troughs in economic health. Understanding the Federal Reserve’s tools for managing the economy’s health is essential to help prepare investors for the incoming ripples.
Much like understanding a portfolio’s downside potential, an investor can mentally prepare for bumps in the road and ultimately avoid making decisions that could be detrimental to the success of a financial plan. The Latin phrase, “Scientia potentia est,” literally means, “knowledge is power.”
Ultimately, investors’ knowledge is the power to unlock possibilities in the future.
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