Inflation is real, it's here and it's rising. But is it bad?
There's a lot of talk of inflation recently. We've all seen the price hikes and felt it in the pocketbook. But let's look at what it is and it is not. Let's also remove the term "transitory" as it has been used, abused and left by the roadside.
As many of you know, a big part of your long-term financial plan focuses on inflation. Whether in terms of increasing our purchasing power or eroding our investments, inflation has a way of helping and hindering. In October of 2021, the financial world received an electric shock in the form of a 6.2% rise in year-over-year inflation. Shocking? Yes. Unexpected? Not really.
Over the last several decades, inflation has hovered at relatively low levels. For the 20-year trailing period between 1998 and 2017, the Consumer Price Index (CPI) averaged 2.14% annually. In the 10-year trailing period between 2008 and 2017, CPI averaged as low as 1.67%! It's impossible for us to assume these low levels were lasting. So it should come as no surprise that, like a rubber band pulled to the extreme, inflation snapped and made us all flinch.
Is +6% inflation the new norm? That's hard to say but before going there, we should get back to breaking down our definition. It's not just gasoline prices. Nor is it about the higher cost of groceries. Economists at the Capital Group put it perfectly:
"Inflation is like chewing gum. It's sticky and flexible, and you definitely don't want to step in it."
So what's the difference? "Sticky" inflation tends to have longer staying power. Sticky categories include rent, insurance and medical expenses. "Flexible" inflation include items such as food, energy and cars. Flexible inflation can, and does, rise faster that sticky inflation. What we see in the news is primarily driven by flexible inflation. In fact, we used to call this "headline" inflation; prices that would rise and fall with the flick of your remote.
As you can see, their projections call for a return to "normal" over the next 3-4 years (I thought we weren't going to use "transitory" anymore?). Although no-one has a crystal ball, it certainly doesn't seem realistic to stay high for long given what we know about the spike (COVID, supply chain issues, reduced labor force, government bailout, etc., etc.) and none of these are, or at least appear to be, permanent circumstances.
So, Mr. Financial Advisor, what does this all mean for me? From a planning perspective, it doesn't change anything. For our clients, we have always used a 3% inflation assumption. Erroring on the side of planning for the worst and hoping for the best, that probably won't change anytime soon. For now, we need more time and data to determine the long-term effects of inflation and see what happens to the sticky chewing gum.
From an investment standpoint, three things to keep in mind:
First, some inflation can be healthy for companies (i.e. our investments). It allows companies to raise prices and enhance profitability in ways they probably couldn't in recent years. It also helps banks and commodity-linked companies that have struggled in a low inflation, low interest rate environment. (Yes, that means mortgage rates will probably go up!)
Second, even in times of higher inflation, stocks and bonds have generally provided solid returns as shown in the chart below. It's mostly in extremes - when inflation lingers above 6% or goes negative - that financial assets have struggled.
And third, sustained periods of elevated inflation are rare. People of a certain age will remember the ultra-high inflation of the 1970s. In hindsight, it's clear that was a unique period. Deflationary periods are much harder to tame, as happened during the Great Depression.
In summary, is inflation bad? In general, it's not bad but it is important. It impacts our forecasts for your financial future as well as our ability to keep pace. But it always has and as long as we continue to plan for it and remain flexible we can continue to anticipate it's long-term effects.
Source: Capital Group Outlook 2022 Edition