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Should You Be Worried About Inflation?
AP

Should You Be Worried About Inflation?

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Inflation may be an unavoidable economic fact of life, but it’s starting to make a lot of people very nervous.

Economists, investors and everyday folks believe inflation is primed for rapid growth as trillions in federal stimulus spending is layered on top of the Federal Reserve’s rock-bottom rates, a nascent economic recovery and hordes of newly vaccinated shoppers who are eager to spend.

The question is whether the coming wave of inflation will be a modest, easily managed wave or a dramatic flood that will roil markets, kneecap savers and cause the Fed to rapidly hike rates, imperilling the recovery.

Many financial professionals aren’t overly concerned that inflation will spiral out of control, especially since the economy has plenty of post-pandemic ground to make up. The administration of President Joe Biden is pinning its hopes on the idea that we’ve moved into an era of easy money without consequences.

But there are plenty of other observers who worry about a replay of the grim days of stagflation in the late 1970s and early 1980s, when inflation spiked and the economy stalled. While such dire scenarios are unlikely, there are steps you can take today to ease your inflation worries.

Inflation Has Been Too Low for Too Long

Congress has assigned a dual mandate for the Federal Reserve: Foster maximum employment and maintain price stability. The FOMC has interpreted maintaining price stability as keeping inflation growing at about 2% a year over the long-term.

The problem is that for much of the past two decades, the Fed hasn’t lived up to that mandate. Using the Fed’s preferred gauge of inflation, core Personal Consumption Expenditures (PCE), which tracks price changes over time without volatile energy and food costs, inflation has remained stubbornly below the Fed’s 2% annual target since the Great Recession, except for a brief stretch in early 2012 and much of 2018.

But even in those periods, inflation never rose above 2.12%, which is hardly reminiscent of the crushing 10% inflation that occurred in the mid-to-late 1970s.

The 2018 period is worth examining more closely. Inflation had managed to top 2% in early 2018, more than two years after the Fed had already begun a campaign of gradual rate increases—a strategy that stoked the ire of then-President Donald Trump. But inflation didn’t stay elevated, dropping from 2.08% in December 2018 to 1.58% by March 2019, and it hasn’t crossed above 1.87% since then.

The Inflation Expectations Game

By continuing to increase interest rates when inflation ticked above its target, the FOMC helped fuel a feedback loop: Investors expected tighter money—higher rates—as soon as inflation inched above 2%.

In a speech last August, Federal Reserve Chair Jerome Powell attempted to reset those expectations. He asserted that one reason inflation had remained so low for so long after the Great Recession was that everyone had assumed the Fed would act when prices got close to its preferred target of 2%.

Take the 10-year breakeven inflation rate. This key metric compares the yield on a 10-year Treasury with the yield on a 10-year Treasury Inflation Protection Securities (TIPS) and acts as a gauge of what investors believe inflation will be on average over the next decade. During 2018 it never hit 2.2, meaning investors never really feared inflation would go meaningfully higher.

Powell hoped to reverse that trend by declaring he would allow prices to rise modestly above their target for a period of time before raising interest rates. “[F]ollowing periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time,” Powell said last August.

At the time, Powell’s stance drew two main questions: How exactly would the Fed get inflation to 2%? And how would it stop inflation from spiralling out of control?

What’s Going on with Inflation Now?

The first question has become easier to answer than the second. In the first quarter of 2021, the federal government passed nearly $3 trillion in stimulus spending. That’s in addition to the $2.2 trillion passed at the beginning of the pandemic.

To put that in perspective, the fiscal stimulus package enacted after the Great Recession was almost $800 billion, or about $970 billion in today’s dollars. At the time, this amount was an almost unimaginable sum—but it’s paltry in comparison to the stimulus of the moment.

In the meantime, Americans started getting Covid-19 vaccinations and economic activity began picking up steam. More than 915,000 jobs were added in March and the unemployment rate dropped to 6%, a far cry from its almost-15% peak in April 2020.

In response to these changes, the Fed increased its inflation forecast for 2021 from 1.8% back in December to 2.2% in March. Should Biden pass his $2.3 trillion infrastructure bill, even more money will flow into the economy. The Fed may even have to update its inflation projections again.

Still, Powell has been resolute in his commitment to seeing the whites of inflation’s eyes before raising rates or paring back quantitative easing. After all, millions remain out of work and the economy is still healing. He’s betting that QE and rates will be adequate to keep a lid on inflation.

But some market observers believe the Fed is being too lax, especially as the 10-year breakeven rate has shot up in recent months. “[F]inancial conditions should remain quite accommodative for a while and in our view risks an overshoot,” said Rick Rieder, BlackRock’s Chief Investment Officer of Global Fixed Income.

What Should You Do about Inflation?

Normal people are also getting antsy over inflation. After dipping to 2.5% at the end of 2020, consumers now expect inflation to rise to 3.3%, the highest level in about six years.

Higher inflation isn’t necessarily a bad thing for average Americans. When inflation runs high, workers are empowered to ask for bigger raises to keep up with the cost of living, and debtholders get a break on their obligations as their borrowed money becomes comparatively less valuable. But life becomes a little more complicated for savers and retirees living on a fixed income since inflation erodes the purchasing power of every dollar.

Still, you don’t want to overreact, said Craig Lemoine, CFP, director of the financial planning program at the University of Illinois.

“If you’re a normal investor and employed, keep doing what you are doing,” he said.

That means to keep saving 10% to 15% of your income in your retirement plan and for other goals. After all, the rise in inflation isn’t life altering. And even if their other holdings seem uncertain, retirees can take solace in the fact that their Social Security check is tied to the Consumer Price Index (CPI), another measure of inflation.

Borrowers may also want to take advantage of low rates while they still can. “Think about refinancing and locking in debts today,” said Lemoine. While mortgage rates have risen a bit in recent months, for instance, they’re still much lower than pre-pandemic levels.

Your Financial Advisor Can Help Mitigate Inflation Stress

Fear of inflation, however, is another issue altogether, said Blain Pearson, CFP, an instructor at Kansas State University, especially for those who don’t feel confident handling their finances. If you find yourself fearing inflation, now’s a good time to lean on your fee-only advisor or look into hiring one.

“One of the primary responsibilities of a financial planner is to reduce the financial stress and anxiety of his or her clients,” said Pearson, who offered some questions you might want to ask your advisor about inflation:

  • Will my cash flow continue to support my family and self if prices rise?
  • Is my retirement plan still on track? Will I have less purchasing power during retirement?
  • Should I reduce the duration of my fixed-income assets? Should I purchase more equity assets with the prospect of rising prices?
  • Do I have too much cash in my emergency fund and, if so, what should you do with it?

An advisor’s answers will depend on your particular situation, and perhaps the answers you get will be the same as when rising inflation wasn’t as big of a concern. But open dialogue and creative thinking will help you feel in control of any market turn.

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