Interest Rates, Inflation, and Investment Strategy - Part Two: Understanding Inflation

In our last blog post, Understanding Interest Rates, we discussed how rising and falling interest rates can impact a healthy economy. In this post, we’re going to talk about inflation - what it is and how it’s affecting our financial plans.  This is a question that many investors are asking themselves these days and it’s important to understand if and how inflation has been contemplated as part of your financial plan.

How Is Inflation Measured?

Inflation is the rate at which money loses its purchasing power over time. As you might guess, there are many ways to measure this. There are various economic sectors, such as energy, food, housing, and healthcare, which can complicate the equation by exhibiting wildly different inflation rates at different times. There is ongoing debate over which figures are most relevant under what conditions.

There’s also today’s inflation rate, versus the rate at which inflation has changed or is expected to change over time.

For example:

• Measured by the U.S. Consumer Price Index, inflation stood at a February 2022 annual rate of 7.9%, fueled significantly by increased energy prices.
  
• Measured by the Intercontinental Exchange (ICE) U.S. Dollar Inflation Expectations, 1 Year Expected Inflation was at 5.74% on March 23, 2022.
  
• Measured by the Federal Reserve’s 10 Year Break-Even Inflation Rate (the U.S. market’s expected average annual inflation rate for the next 10 years), expected inflation was hovering at around 2.94% on March 23, 2022.

That’s a wide range of numbers for seemingly the same figure, but they all share one point in common: inflation is higher than it’s been in quite a while. Just visit the Dollar Tree - now the $1.25 Dollar Tree (or nearly anywhere else these days), to see that $1 doesn’t buy what it used to.

But what does all of this mean? It helps to consider current events in historical context for more information and insights.

Inflationary Times: Past and Present

Unless you’re in your 60s or older, you’ve probably never experienced steep inflation in your lifetime - at least not in the U.S., where the last time inflation was as high (and higher) was in the early 1980s. After years of high inflation that began in the late 1960s and peaked at 14.8% in 1980, Americans were marching in the streets over the price of groceries, waving protest signs such as,“50¢ worth of chuck shouldn’t cost us a buck.”

During his 1979-1987 tenure, Federal Reserve chair Paul Volcker is credited with handling the runaway inflation by ratcheting up the Federal target funds rate to a peak of 20% by 1980. (Compare that to the recent increase to 0.05% as discussed in our last post.) Aimed at reducing the feverish spending and lending that had become the status quo, Volcker’s strategies apparently helped. By 1983, inflation had dropped considerably closer to its target rate of 2%, around which it has mostly hovered ever since. Until now.

The Inflationary Past Is Not Always the Answer

So why not just ratchet up the Fed’s target rates as Volcker did? Unfortunately, it’s not that simple.

First, as described in this commentary, “Should We Be Scared of Inflation?” there are several broad categories, such as supply and demand, rising labor and production costs, and a nation’s monetary policies—each of which can contribute to inflation individually or in combination. This means each inflationary period is born of unique circumstances. So, even if a solution seems relatively reliable, you never know for sure how each economy will respond.

Second, even if an inflation-busting action does work, left unchecked, the side-effects can be worse than the inflation itself.

Volcker’s actions are a case in point. The higher target rates not only tamed inflation, they weakened the economy significantly, leading to an early 1980s “double dip” recession and high unemployment. Overall unemployment hovered above 7% for several years, with some sectors such as the construction and automotive industries experiencing double-digit figures. Even if the outcome was worth the pain involved, it’s not a solution people are likely to want to repeat. 

“If/Then” Stage Two Thinking

Are we doomed to reach double-digit levels of inflation this time, face another painful recession, or both? As always, time will tell. However, in the face of today’s challenges, we choose optimism over fear, not because we’re naïve or blind to the facts, but because we are guided by an economic principle known as stage two thinking.

Economist Thomas Sowell has described staged thinking in his pivotal book, “Applied Economics: Thinking Beyond Stage One.” Basically, before acting on any event’s initial impact, it’s best to engage in stage two thinking, by repeatedly asking a very simple question: “And then what will happen?”

By applying stage two thinking to inflation, we can accept that, yes, inflation has become uncomfortably high. Labor costs, supply constraints, low interest rates, and high spending have all likely contributed to inflated costs, which can then further aggravate these same influencers, and inflation could spin out of control.

But then what will happen? In reality, next-step responses are already taking place. The Fed has raised interest rates once, and hopes to continue raising them throughout 2022. Likewise, businesses are revisiting their growth plans, and consumers are thinking twice about their purchases, especially in markets where inflation is having its greatest impact.

It probably won’t happen overnight, but these next steps should chip away at inflation. True, this could lead to a recession … or not. We hope not. Either way, then what will happen? Once again, governments, businesses, and individuals will likely adjust their behaviors and expectations in response. 

Investing in Inflationary Times

Even if the odds are heavily stacked in favor of the taming of inflation over time, this is not to suggest it will be easy. And even if we “win” in the end, it’s unlikely it will be obvious until we are able to look back at the events in hindsight. So as we move forward, you may repeatedly question what these influences mean today to you and your investments.

We’ll discuss thoughts on that in the final post in this three-part series. 

Inflation impacts everyone and should be part of a comprehensive financial plan. When creating plans for clients, we stress test for the plan to make sure that it still works even if inflation is higher than expected. If this is something that would be helpful to you, reach out and schedule a complimentary consultation. We can see if we’d be a good fit and talk about taking the next steps together!