Understanding Inflation
Has rising inflation got you down? In our last piece, “Understanding Interest Rates,” we explored how rising and falling interest rates can impact a healthy economy. Today, let’s add inflation to the conversation.
How Do We Measure Inflation?
As said by economists: “Inflation is the rate at which money loses its purchasing power over time.” Said another way: “Because of inflation, a dollar today doesn’t buy as much as tomorrow.” We worry about inflation and its impact on fixed-income investments and people living off of fixed income. We worry about inflation for people whose wages don’t increase as quickly as the cost of their living. We worry about inflation for people who don’t save and invest with inflation as a risk to manage.
There are many ways to measure inflation. 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. And there is ongoing debate over which figures are most relevant under what conditions.
There also is 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.
Source: US Bureau of Labor Statistics
While that’s a wide range of numbers for seemingly the same figure, they all share one point in common: By nearly any measure, inflation is higher than it’s been in quite a while and everyone reading this is seeing price increases around them.
But what should we make of that information? As usual, it helps to consider current events in historical context to discover informative insights.
Inflationary Times: Past and Present
Unless you’re at least in your 60s, 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 a feverish 14.8% in 1980, Americans were literally marching in the streets over the price of groceries, waving protest signs such as, “50¢ worth of chuck shouldn’t cost us a buck.”
Paul A. Volcker, former Chairman of the Federal Reserve, in 2006. Kenneth C. Zirkel, CC BY-SA 3.0, via Wikimedia Commons
During his 1979–1987 tenure, Federal Reserve chair Paul Volcker is credited with routing the runaway inflation by ratcheting up the Federal target funds rate to a peak of 20% by 1980. (Compare that to the recent target range of 0.25-.50%, discussed in our recent blog on Interest Rates). Aimed at reducing the feverish spending and lending that had become the status quo, Volcker’s strategies apparently effected a cure or at least contributed to one. By 1983, inflation had dropped considerably closer to its cooler target rate of 2%, around which it has mostly hovered ever since. Until now.
The Inflationary Past Is Not Always Prelude
If we are worried about inflation, why not just ratchet up the Fed’s target rates as Volcker did? Unfortunately, it’s not that simple.
First, as we described in a previous blog, “Inflation: The Was, The Is, and The Will Be,” there are several broad categories- such as price, wages, and money supply—each of which can contribute to inflation individually or in combination. This means each inflationary period is borne of unique circumstances. So, even if a “treatment” seems relatively reliable, you never know for sure how each “patient,” or economy, will respond.
Second, even if an inflation-busting action does work, it’s not unlike treating cancer through aggressive chemotherapy. Left unchecked, the side effects of the treatment can be detrimental.
Volcker’s actions are a case in point. The higher target rates not only tamed inflation, but they also 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 course one embraces with enthusiasm.
Where Do We Go From Here?
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 judicious optimism over paralyzing fear. This is not because we’re naïve or blind to the facts, but because we are guided by the key investment principles of keeping diversified and keeping our eyes on the right horizon.
We can accept that, yes, inflation has become uncomfortably high. We know that the Fed has raised interest rates once and hopes to continue raising them throughout 2022. Markets are responding. 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. Yet, we are also in dangerous world times with Ukraine and Russia, which also threaten to slow economic growth (slowing inflation) and potentially encourage more government spending (encouraging inflation.) There is constant and dynamic tension.
Investing in Inflationary Times
Even if odds are heavily stacked in favor of our taming 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. Until then, we continue to avoid making emotional investment decisions relying on historical data and diversification to weather whatever inflationary storms we may face.
Contact us if you need help developing a plan to help you weather those storms.
