The Possibility of Higher Inflation Rates
What’s up with inflation? Over the past several weeks, you have probably noticed widespread news coverage about the risks of rising prices in 2021 and ultimately higher inflation rates potentially for years ahead.
The recent publicity about higher prices has been as sudden as it has been surprising. Many people assumed that we would never again see those dreaded decades of the 1970s and 1980s when annual price changes were much higher than the tepid inflation rates of 1% to 2% experienced in recent years. Last year’s dramatic Covid-19 economic shutdown seemingly cemented these low inflation expectations among both investors and consumers.
However, financial news sites and fixed income investors have apparently forgotten all about that! Some reports are even suggesting that the US Government’s no-expense spared response to the Covid-19 recession has placed the economy on an inevitable path toward inflation rates unseen since decades ago.
Understanding the Current Inflation Scare
In addition to the $1.9 trillion Covid-19 economic relief law recently signed by President Biden, the US Federal Reserve Bank, which for decades has pursued programs aimed at curbing inflation, changed its inflation targeting policy last year and has recently announced (on several occasions) that temporarily higher inflation would be acceptable if it promotes the goals of reduced unemployment and stronger economic growth.
These recent policy developments reflect the concerns of US political and economic officials who want to avoid the risks of deflation, since inflation rates have actually been in decline over the past 30 years. In fact, since the 2008-09 Great Recession, economic policy makers around the globe have tried to stimulate stronger economic growth, but they have been largely unsuccessful.
The sudden inflation scare, if it were to come to pass, may certainly impact all of us. However, the stakes may be especially high for many of you who are mid-life professionals in transition and thinking about plans for your second half of life.
The Impact of Higher Inflation on Mid-Life Professionals in Transition
Regardless of whether you are planning to retire soon or to continue working, an unexpected rise in prices may present even greater challenges for your personal finances and investments than for people who are younger. As you approach this life stage, your future sources of income may not keep up with rising prices.
In addition, high inflation rates can negatively affect your investments, especially prices for fixed income instruments. And indeed, that is exactly the dynamic that has played out so far in 2021. Through March 18, 2021, the Bloomberg Barclays US Aggregate Index, a widely recognized index that tracks the US fixed income market, has declined 3.01%.
Although not entirely surprising, those results are very disappointing for investments that are considered low risk. The negative returns in fixed income this year also represent quite a reversal from 2020 when that same index registered a return of 7.51%, due to the Covid-19 recession and during a year when inflation was far from everyone’s mind.
What should you do?
Four Financial Planning Strategies
If you are a mid-life professional in the midst of career change, the impact of higher inflation rates can be especially harmful. You spent a lifetime saving for a life of financial independence and higher inflation could eat up the savings you’ll need after leaving the workforce.
Here are four strategies to consider so that you can confidently face the inflation dragon:
1. Prepare a Cash Flow Based Financial Plan
Last year, I wrote a blog about the importance of considering inflation as a key risk in preparing for your next life stage. That article introduced the idea of cash-flow based financial planning as a very strategic tool to evaluate how inflation may impact your financial needs over the years.
Specifically, a cash flow analysis will help you understand how your investments and other savings may pay for the goods and services you will need over the long-term. This kind of planning can help you evaluate how you might sustain your finances under different inflation scenarios and the potential steps you can take to stay on track if the long-term rate of inflation changes from what we have seen over the past few decades.
Today’s long-life expectancies require us to consider the likelihood that our money will need to last much longer than may have been necessary for previous generations. A carefully crafted financial projection can help you understand inflation dynamics and the possible declining purchasing power of your savings over a 20 or 30-year timeframe.
2. Think Scenarios and Not Predictions
When in doubt, I always refer to reading the quotes of the famous baseball player Yogi Berra. I am guessing Yogi did not know much about financial planning and investments, but he apparently had a certain wisdom. When I think about investing and economics, I often refer to this Yogi gem: “It is hard to make predictions, especially about the future.”
Any of us, including financial professionals, can fall into the trap of believing that we must have the skill to predict the future or in this case to know when a new inflation trend (higher) may re-emerge. The inconvenient truth is that these matters are very unpredictable and that most economists (even those with fancy PhDs from the greatest universities) cannot accurately and consistently make such prognostications. Why should any of us pretend that we have the knowledge to do so?
You do not need to be wedded to a particular inflation outcome or prediction. In spite of the sensational media coverage, inflation rates have not yet increased! Although inflation may likely increase over the next several months, that outcome most likely may not materially impact your long-term finances. However, it is far from certain that the long term inflation rate will increase, even if the next year does bring higher prices.
Due to the uncertainty about such matters, I recommend that you think about scenarios and how you could adjust your finances in response to different circumstances, including higher inflation. For example, I think it is very reasonable and prudent to use 2% as a long-term inflation assumption for a financial projection. However, it may be wise to also test your cash flow projection against a higher inflation rate, such as 3% or even more, just in case the recent concerns about inflation eventually come to pass. That way, you can begin to understand how you could respond if the more aggressive inflation assumption were to occur.
3. Review Your Asset Allocation
Reviewing your asset allocation during a time of change or career transition may be very appropriate. The mix of equities (growth-oriented investments), fixed income instruments (income producing investments) and cash may likely have a significant impact on the long-term returns of your portfolio.
Within the broad equity and fixed income sectors, there are steps you can consider that may prove useful in preparing for the possibility of higher inflation. Equities can often act a hedge against higher inflation, and especially so over the long term. But they come with the risk of greater volatility.
In the bond sector, inflation protected bonds may also be beneficial, as well as purchasing fixed income instruments which have short maturities. However, these investments may present other risks that need to be evaluated in the context of your overall portfolio design.
4. Remember to Project Healthcare Costs
The idea of higher inflation is a very recent development which has just started to receive attention this year. However, the healthcare sector of the economy has experienced high inflation for as long as three decades – this trend is certainly not at all new!
Consequently, a detailed financial projection should include a separate line item for healthcare expenses, with an assumed inflation rate for those costs that are closer to 6% (not 2% or 3%). Last month, I wrote a blog about how you can approach the task of preparing for these costs and understanding your situation.
It is likely that you may consume more healthcare expenses as you age, adding an additional long-term financial need along with the attendant higher costs related to inflation. Estimating these expenses is an especially important ingredient to add to your planning recipe!
The most important approach about inflation, the economy, and your investments may be to stay pragmatic, monitor the trends over time and not be overly swayed by sensational headlines about the risks ahead. Inflation rates have not yet increased; it is only investors’ expectations about inflation that have changed. This does not mean that the economy will actually experience greater inflation in the future.
Although we should not ignore the recent developments about the possibility of rising prices, you may be better served using the four steps above to evaluate your situation and potential changes that may be appropriate to support your long-term goals. As always, please feel free to contact me with your comments, or to help review your situation.