Inflation is currently the biggest topic throughout the financial industry and no one seems to agree on exactly how to approach it.
According to the Federal Reserve and US Treasury, the current bout of inflation hitting the United States is transitory and will return to traditional levels as supply chain disruptions are resolved. On the other hand, many economists and investors believe that elevated inflation is here to stay for a bit as government stimulus floods the economy and wages continue to push upward.
So which side has the correct interpretation? Certain factors can be used to credit or discredit the ideas coming from both camps, but for the present time, inflation is here and it’s making things more expensive than anticipated. But before you reposition your investments, it’s important to understand how inflation affects savings, how to preserve purchasing power in response to it, and what actually can be done to grow wealth in a high inflation environment.
What is Inflation?
The economic definition of inflation is a general rise in prices in an economy over a specific period of time. Inflation is measured using a few different gauges, usually by combining the prices of a basket of goods and services and looking at the overall rate of change. The opposite of inflation is deflation, which means a general decrease in the price of these baskets of goods and services.
Inflation affects people differently. When the overall price of goods and services increases, the purchasing power of that economy’s currency decreases. This is bad news for savers – the money you save can buy fewer goods than it did the previous year.
If you’re a debtor, inflation can be a good thing since your obligation will get smaller when the purchasing power of a dollar decreases. Inflation also tends to push wages up, which can be a boost to younger workers looking to climb the workforce ladder while paying down debt.
In an ideal economy, inflation will settle into a Goldilocks zone. Too much inflation can destroy purchasing power and make things unaffordable to the poor and middle class. Deflation is also detrimental to an economy.
Yes, everyone wants cheaper prices, but if the value of money increases over time, the economy will grind to a halt since no one will buy something today that will be cheaper tomorrow. John Maynard Keynes called consumers perpetually waiting for better deals the ‘Paradox of Thrift’ and believed it would cut aggregate demand and slow the economy.
The Federal Reserve attempts to keep the rate of inflation steady by adjusting interest rates, namely the Fed funds rate (which is the rate banks charge each other for overnight lending). When inflation falls below the target, the Fed will cut interest rates in order to promote borrowing.
When inflation gets too high, the Fed will increase rates to curtail borrowing. The US government and Federal Reserve mainly use two key indicators to measure rates of inflation- the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) index. Both indices use a basket of consumer prices to measure rates of change, but the components of each index vary.
How Does Inflation Affect My Retirement Savings?
Inflation is most detrimental to people with fixed incomes – especially retirees. After saving meticulously for decades, many retirees are rightfully concerned about the purchasing power of their nest egg facing inflation. And unfortunately, older savers get hit from multiple angles.
For starters, retirees no longer can count on wage increases to combat inflation (unless you count social security benefits, which do increase with inflation). With no steady paycheck, retirees depend on savings to last as long as possible. Inflation naturally erodes these savings and choices must be made in order to keep up.
To combat inflation, investors can add a little more risk to their portfolios, but this is something retirees often find hard to stomach. When faced with rising inflation on a fixed income, taking more risk in the markets could mean sleepless nights for retirees, who would much rather have peace of mind than 100 extra basis points of returns.
Protecting Your Savings From Inflation in Retirement
You should always seek to protect your hard-earned savings from inflation, especially when prices are expected to run high for the foreseeable future. Here are a few steps to consider if you want to shield your savings.
- Consider Your Social Security Options – Putting off Social Security as long as possible is usually sound financial advice. The longer you wait, the fatter your check will be when they do start coming in. But if rising inflation causes you to dip deeper into your nest egg than you originally planned, you might want to revisit your Social Security timeline.
- Allocate More Capital to Stocks – The best method of combating inflation over the years has been a strong allocation to equities. Inflation may erode savings, but stocks can benefit from inflation as companies take in more profit from higher prices while also borrowing cheaply due to low-interest rates. High inflation doesn’t also mean high stock returns, but equities have consistently been the best way to preserve purchasing power in the face of rising inflation.
- Review your retirement plan – Evaluate your retirement plan regularly to ensure that it reflects your personal risk tolerance and is in sync with changes in your lifestyle.
Buckle up… It’s going to be a bumpy ride, but if you have the right financial advisor as your co-pilot, you can navigate the best way to protect your nest egg from inflation.
Ascendant Financial Solutions, Inc. is an independent SEC Registered Investment Advisory firm serving clients in the Flagstaff and Phoenix, Arizona areas. With more than thirty years of experience in the financial industry, we partner with families, business owners, and retirees to ascend to greater financial heights on their journey to financial freedom. No matter how complex your financial goals are, our team will rise to the challenge to help you meet your goal.