The most obvious problem with inflation is that it erodes wealth. I first wrote about this problem a long time ago May 2020, while inflation had been moving at a moderate pace for more than three decades. Since then, inflation has come back with a vengeance: gasoline prices are skyrocketing, groceries are more expensive, and vehicle prices have skyrocketed.
But the most insidious effect of rising inflation is that it fundamentally erodes confidence. It is a highly destructive force that spills over into many different areas, as detailed below.
Inflation destroys confidence in saving and investing
By definition, inflation eats away at investment returns, making it harder for investors to generate the growth needed to achieve their financial goals. As the chart below shows, inflation-adjusted returns for major asset classes are often negative during periods of high inflation. As a result, returns on the classic 60/40 combination of stocks and bonds have often landed in negative territory during periods of inflation.
How does inflation affect investments?
The negative effect of inflation on investment returns adds significant uncertainty to the planning process for individual investors, financial advisors and institutional investors such as pension plans. While I have no idea what impact inflation might have on my future returns, I have no way of estimating how much I might need to set aside to fund my future goals.
Inflation hampers workers’ ability to plan for retirement
This is closely related to the previous point. During periods of high inflation, investors may need to set aside a higher percentage of their income for retirement savings. At the same time, the rising cost of living can increase the risk of prematurely exhausting a retirement nest egg. And as John Rekenthaler pointed out, higher inflation that occurs during the first five years of retirement can be particularly damaging because it permanently increases the total value of withdrawals from the wallet.
How does inflation affect retirement withdrawals?
Additionally, many retirees rely on portfolio withdrawals to fund a higher percentage of their retirement expenses. As we have discussed in the past, inflation is a major swing factor that can affect how much retirees can safely withdraw from their portfolio each year. The classic 4% rule of thumb for retirement withdrawals assumes that retirees adjust each year’s withdrawal amount based on inflation, but a higher than average rate of inflation can make this strategy untenable.
Inflation hampers consumers’ ability to make rational buying decisions
If I’m making a major purchase, I need to know how much money I can spend, how much the item will cost, and what value it will create compared to other things I might spend money on. Inflation complicates these three things. It can also lead to problematic consumer behavior, such as hoarding. If I’m worried that the cost of toilet paper or nutrition bars will only go up, I might be tempted to load up the cart on my next trip to Costco. This type of panic buying, in turn, can create shortages or fuel further inflation by artificially stimulating short-term demand.
How does inflation affect purchasing power and consumer behavior?
Inflation can also complicate the decision-making process for the most expensive items. For example, if I was thinking of replacing my car in the next few years, should I buy now to avoid the risk of prices being much higher in 12 months? Or take the opposite course and wait in the hope that price levels stabilize? Or maybe with gas prices so high, I don’t even need a car at all. This type of uncertainty not only creates stress for people trying to figure out how to spend their money, but can also lead to unintended consequences by increasing the level of friction in purchasing decisions.
Inflation rewards debt financing
The basic calculation of inflation means that when inflation increases, the future value of a currency decreases. This makes it more attractive for borrowers to pay off debt with money that is worth less and less. This can benefit both households with fixed-rate debt such as mortgages and businesses with leveraged balance sheets (not to mention governments facing bloated deficits).
Over time, however, higher inflation can hurt borrowers, as it is usually followed by higher interest rates, increasing the debt burden for anyone funding new loans or holding variable rate debt. . It can also create friction issues similar to the one I discussed above. the prospect of higher interest rates and uncertainty about future property values can cause buyers to make poor decisions if they rush to buy a home sooner than they otherwise would.
Reasons to hope
Certainly, there could be positive signs of slowing inflation. The monthly consumer price index in the United States rose at a much weaker pace in April, although it rose again with the latest report in May. Recent data from the Labor Department suggests that the pace of job growth and wage growth has moderated. And as Bloomberg recently reported, the prices of some of the underlying components used to produce food, electronics and transport – namely fertilizers, certain types of semiconductor chips and containers of shipping – have recently fallen from their previous highs.
Expectations of future inflation over the next five years have also declined. Based on the spreads between the nominal yields on the Treasury and those on Treasury inflation-protected securities with the same maturity date, the market had been pricing in a five-year break-even inflation rate of 2.76% at June 6. It’s actually a bit below 3.20% in the long term. -long-term average since 1913.
At this point, investors can only hope that inflation will return to more normal levels soon enough. In the meantime, it will continue to have far-reaching effects for both consumers and investors.