What should you do about inflation?
If you’re of a certain age, you may remember the inflation of the 1970s and early 1980s, along with Nixon’s wage and price controls and Ford’s Whip Inflation Now buttons. Inflation hit 13% in 1980, probably dooming Carter’s re-election chances. Thiry-year mortgage rates peaked at 18% in 1981. (Yes, 18%.)
If you’re of a younger age, you’ve never experienced meaningful inflation until recently when you tried to buy a used car or go grocery shopping. For the past 10+ years, the Fed had been trying to increase inflation to reach 2%, rather than lower it.
Well, inflation is back and while there’s a healthy debate in the econosphere about how long it will last, it’s scaring consumers, politicians, and investors. In this note, I’ll focus not on whether it’s here to stay but on how you can partially protect your future purchasing power from inflation.
Inflation is a subtle risk to manage. Unlike hurricanes, house fires, or various other accidents, it’s not an immediate event that causes catastrophic loss and then departs. Inflation is more akin to a dripping gutter or eating too many carbs — you likely won’t notice the damage for a long while and then one day you’ll pay the price for years-long inattention.
Because our brains are wired to focus on the short-term and we don’t have a good intuition for the long term effects of compound interest (that’s essentially what inflation is), we easily ignore the future risks of inflation. We complain when groceries prices go up but that’s all we’re willing to do about it.
To give you a sense of its effect over time, if inflation remains at 4%, your purchasing power is halved in ~20 years. That’s quite meaningful over the time horizon of a 30-year retirement.
What can you do about it? There is no cost- and risk-free investment strategy to fully protect you from future purchasing power losses, but there are some sensible moves to make if you believe that inflation will be as endemic as COVID-19.
1. US Treasury Series I inflation bonds
They are the perfect inflation hedge and should be part of most people’s portfolio. I wrote elsewhere about these bonds. Keep in mind that you’re limited to purchasing $10,000 per year per person, so for a meaningful portfolio, that doesn’t go very far in terms of overall inflation protection.
2. Social Security claiming age
Social Security has a built-in inflation adjustment (aka “COLA”) and it’s another reason why it makes sense to delay claiming your benefit until age 70 so you can maximize its inflation shield. This is worth doing even if you must draw down other savings first.
Traditionally, investing in stocks has been a good long-term hedge against inflation. However, this relationship is not guaranteed nor is it necessarily true in the short-term. It’s complicated because when inflation occurs, future earnings should increase but so should interest rates.
A simple model of how to value a stock is if the future earnings of the company are growing faster than interest rates, then stock prices should rise. But stock prices should fall if interest rates are growing faster than earnings are growing.
Over the past 100 years or so, inflation has averaged 3% per year and equity returns have averaged 10%. Stocks have been a good long-term inflation hedge, but there have been many roller coaster rides along the way.
4. Real estate
Commercial real estate valuations could be thought of similarly to stocks — inflation will increase the cash flow of the property (e.g., higher rents) but higher interest rates will reduce the property value. The growth in real estate values has exceeded the rate of inflation over long periods of time but at a lower rate than stocks have grown.
5. Long-term bonds
Long-term bonds are usually a poorly performing asset during times of increasing inflation. If you believe future inflation will be higher than today, you do not want to invest in long-term bonds now.
A simple model for valuing a bond is that the investor receives the sum of all future interest payments plus the principal repayment at the term of the bond. However, unlike stocks and real estate, these payments are fixed and unadjusted for future changes to inflation. In a scenario of future inflation, the payments you receive do not increase and thus, bond values decline.
Note that the US Treasury Series I bonds (#1 above) are an exception to this rule and that’s why they’re such a good inflation hedge.
6. Long-term insurance products
Insurance contracts such as long-term care insurance or lifetime annuities that do not have an inflation adjustment have decreased value when inflation appears. The future benefits are fixed, thus the purchasing power they will deliver will be reduced.
With long-term care insurance, you want to carefully consider the trade-off of including an inflation adjustment in your benefit. There’s no free lunch here, so if you include an inflation adjustment, the premiums will be higher (or the benefits will be lower). With lifetime annuities, the same calculus holds — you can purchase them with a built-in inflation adjustment but you’ll either pay more upfront, or initially receive less for a given purchase amount.
This does not make these insurance products a poor choice, they’re just not designed to be an inflation hedge.
Holding large amounts of cash in short term savings is at best, a break-even return. As I mentioned, inflation has averaged 3% over the past 100 years and that’s about what short-term investments (think CDs or money market funds) have also averaged over this period. When you factor in taxes, holding cash is a loser when trying to maintain purchasing power.
Today, the nominal returns on cash are near 0%. That’s not a great deal when inflation may be 4 or 5% at the moment. Holding cash is like paying a small inflation tax every day.
In sum, inflation is a long-term threat to your purchasing power but it’s almost imperceptible in the short run. There are intelligent financial planning moves you can make to blunt its future effects but, like any insurance, they all come at a cost.