By Michael Hathaway, CFP®, CFA®, AIF®
If you’ve been following the news lately, you’ve probably heard commentators and analysts debating about the dramatic rise of inflation and whether it is “persistent” or “transitory.” What may have seemed like a slight inconvenience at first is now becoming a much larger issue as people watch their purchasing power degrade right before their eyes.
As the holiday season approaches, many are wondering how much they can afford to spend on their loved ones or how seriously their retirement plans will be affected. These are valid concerns, especially after the heaviness of the ongoing COVID-19 pandemic. It’s completely understandable to worry and wonder when things will go back to normal.
The best way to assess the situation is to take a look at the factors surrounding why inflation is rising. The COVID-19 pandemic was unlike anything the world has ever seen. The entire global economy came to a complete standstill for the only time in modern history. It’s to be expected that the rebound from such a once-in-a-lifetime event will be just as enigmatic as the event itself. Here are some reasons why inflation is at an all-time high and what it means for your long-term purchasing power.
What Is Inflation?
According to Investopedia, inflation is “a decrease in the purchasing power of money, reflected in a general increase in the prices of goods and services in an economy.” (1) It can be characterized as persistent or transitory. Transitory inflation (2) is temporary and happens when supply doesn’t meet demand. If left unhandled, it can turn into persistent inflation, (3) which results in a more permanent increase in prices due to a continuous mismatch in supply and demand.
The Consumer Price Index (CPI) is a common measure of inflation. The most recent CPI report from September 2021 suggested that inflation has risen an astounding 5.4% over the past year! (4) That is significantly higher than the typical 2% rise we see in an average year.
Why Is Inflation So High?
To better understand if inflation will last, let’s take a look at the factors contributing to its rise.
- Devalued Dollar
When the COVID-19 pandemic first hit and the global economy shut down back in March 2020, many wondered if the economy was going to collapse. With millions of Americans furloughed or without jobs, drastic measures had to be taken to keep the country afloat.
The U.S. government instituted expansionary monetary and fiscal policies in order to pump money into the economy. This was accomplished through stimulus payments, extended unemployment benefits, small business loans, moratoriums on evictions and student loan payments, and changes to the rules around required minimum distributions from retirement accounts.
This is all to say that the money supply in the U.S. increased at a rapid rate, jumping from $15.5 trillion in February 2020 to $18.8 trillion in October 2020, an increase of over $3 trillion dollars (or 21%). (5) Though experts agree that these drastic measures were necessary to keep the economy from collapsing, they also agree that the increase in money supply devalued the dollar, meaning it takes more dollars to buy the same item since each dollar is less valuable. This was the beginning of the resurgence of inflation.
- Supply Chain Disruptions
If there’s one thing that’s been in the news even more than inflation concerns, it’s supply chain disruptions. With the vaccine rollouts and the uneven return to pre-pandemic life, companies have struggled to keep up with manufacturing and distributing goods. This is because many distribution centers cut their hours when the global economy came to a halt in anticipation of a huge drop in demand for consumer goods. The drop in demand, however, did not come (thanks, at least in part, to the financial stimulus).
As people across the globe spent days, then weeks, then months in their houses, demand skyrocketed for exercise equipment, home goods, and office supplies. Factories increased their output, but the distribution chains have struggled to get everything where they need to be.
Additionally, the increased production has also caused a shortage in raw materials (which also need to be extracted or developed), thereby exacerbating the gap between overall supply and demand for even basic items. As demand continues to outpace supply, prices are driven higher and higher.
- Labor Shortages
Continued labor shortages are another factor driving inflation. In what is being called “The Great Resignation,” millions of workers across America have quit or considered quitting their jobs as they reevaluate the role that work plays in their lives. (6) As such, many companies are finding that they have to pay higher wages in order to attract and retain employees. These increased costs often get passed through to the customer in the form of increased prices for goods and services.
So, Will Inflation Last?
Several points seem to indicate that the high rate of inflation we are experiencing right now is transitory in nature. The three main components of inflation mentioned above are all reactions to the pandemic and subsequent economic shutdown. Prior to March 2020, the U.S. economy was performing quite well and on track for another 2% inflation year. (7) This indicates that the inflation we are experiencing right now is just a reaction to a reaction, so to speak, and not a permanent increase. However, government policies and market reactions might extend the “transition time”.
Federal Reserve Chair Jerome Powell testified to Congress in June 2021 that “As these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal.” (8) The central bank is forecasting inflation to decrease to 2.2% in 2022 and carmakers expect their chip shortages to be resolved by 2023, an indication that supply chain disruptions should be resolved in the short-term future. (9) While it can be disheartening to hear that high levels of inflation will last into 2022 and possibly 2023, (10) it’s good to know that it likely won’t be the rampant out-of-control inflation of the 1970s.
Let Us Help You Protect Against Inflation
If you’re concerned about how inflation is going to affect your investments and financial plan, know that you don’t have to go through it alone. Experts agree that emotional investing and making financial decisions based on the wild day-to-day changes of the market are the last thing you want to do in response to rising inflation.
Be sure to review your investment and retirement plans for proper diversification and risk tolerance levels. If you have questions or concerns about your portfolio, or would like to discuss how rising inflation could impact your financial plan, reach out to us today. At Epsilon Financial Group, we have the tools and expertise to guide you through today’s high-inflation environment. Call us at (707) 428-5500 or email Mark@wealthmatters.com to review your plan today.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, Chartered Financial Analyst® (CFA®), and Accredited Investment Fiduciary® (AIF®) professional; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.