Inflation has been quiet for a very long time. In fact, other than periodic spikes in energy prices, inflation has been more a matter of speculation than reality. Prices have generally tended to be predictable and that’s been a benefit to both consumers and businesses.
But there some signs that inflation may be about to return. If it does, how should we prepare?
Why Higher Inflation May be on the Way – And What to Do About it
Since the early 1980’s central banks all around the world have been working to squeeze inflation out of the economy. This collective policy has lead to a multi-decade run of disinflation. Disinflation is the process of lowering the rate of inflation, and since the policy was implemented, inflation has declined from double digits down into very low single digits. Sometimes it’s even bumped close to zero.
We could say mission accomplished! Unfortunately, economic prosperity is a dynamic, not a destination, and central bankers can rarely rest on past accomplishments.
One of the fears in recent years is that disinflation would eventually succumb to deflation, which is an entirely different and less holy outcome. Under deflation, wages, asset values and general price levels decline. While that may seem like a positive development, it’s actually a recipe for an economic depression. In fact it was the driving force that launched the Great Depression in the 1930’s. The problem with deflation is that it feeds on itself and turns ugly. That’s what central banks want to avoid.
There are now indications that central banks may be about to reverse course and let a bit of inflation into the mix. Inflation, it’s thought in certain quarters, might actually remedy what ails a very sluggish economy.
Are we ready for the change?
Inflation and Your Income
This could play out one of two ways. If wage growth reacts quickly to higher inflation, consumers may be in a position to increase spending. That will increase demand and hopefully begin creating new jobs too. On the other hand, if wages continue to run behind the price curve, higher prices could quickly overrun salary increases. If that happens, the economy could slow even more.
We probably should expect the second scenario to play out. High unemployment leads to a doubtful starting point for higher wages. Now would be an excellent time then to cut living expenses in anticipation of higher inflation. In particular, we should be hesitant to take on any new expenses or financial entanglements, at least until we get a clear idea as to which way the wind is blowing.
Inflation and Your Debt
Inflation usually translates into higher interest rates. That makes a strong case for 1) locking in interest rates now while they’re still low, and 2) converting variable rate debt to fixed rate debt as soon as possible.
If inflation is coming, we should no longer bank on a continuation of the very low interest rates we’ve reliably had over the past few years.
Inflation and Your Mortgage
The prospect of higher inflation should be a siren call to refinance your mortgage now, if you haven’t done so recently. This may be your last chance to lock in the lowest mortgage rates in history. Throw the election in with the prospect of higher inflation and we could be looking at substantially higher mortgage rates a year from now.
Inflation and Your Investments
Since higher inflation will mean higher interest rates, the impact on your investments could be substantial. Here is how inflation can impact some common investments:
Equities. Because interest bearing investments compete with stocks, rising interest rates may not bode well for stocks. Higher interest rates make fixed income investments more attractive. Alternatively, certain stock sectors, like resource stocks, may benefit from higher inflation.
Fixed income assets. This is probably not a good time to commit your money to a five- or ten-year certificate of deposit or Treasury note. You’ll be tying up your capital at very low rates of return while higher returns will be coming available. Money market funds and very short term securities may not pay much interest, but they’ll keep your cash free to take advantage of higher rates later.
Commodities. Energy in particular tends to benefit from inflation, but other sectors may present opportunities as well. Construction materials, precious metals and rare industrial commodities may benefit as well.
How to Beat Inflation
Over the long term, prices tend to go up — and the purchasing power of your dollar tends to go down. It’s the way of things with a fiat currency: Over time, your purchasing power is going to decline, and you’ll need more dollars to pay for the same product or service. Just take a look at this historic inflation calculator for an example of how the purchasing power of the dollar has eroded over time. What you need are some core strategies to beat inflation and protect the purchasing power of your wealth.
If you are wondering how you can offset the inevitability of inflation, here are 6 strategies you might employ:
This is one of the simplest — and possibly the safest — strategies for offsetting inflation. Treasury Inflation Protected Securities (TIPS) are special bonds that are periodically adjusted to keep pace with inflation. While you probably won’t earn a huge return, your money will be backed by the U.S. government, and your purchasing power will be preserved. I-bonds are another inflation protected Treasury investment that can help you beat inflation. However, it is important to realize that, like all bonds, the possibility of default is still there.
2. Index Funds
Given a long enough period of time, past performance indicates that the stock market does not lose. (Although there is a first time for everything, and you are still at risk.) Keep in mind, the markets rise and fall, so we are talking long-term investments, not money you will need in a few months or a couple years. Indeed, over the long haul, the overall stock market offers inflation-beating returns. However, individual stock-picking does not provide the same potential for success. You can advantage of the power of the entire stock market with index funds and ETFs that follow the market. Fees are low, and if you wait long enough the returns should help you outpace inflation.
If you can stomach the volatility and the risk many associate with commodities, you might be able to stay ahead of inflation. People will always need commodities, so, due to that demand, commodities are inflation sensitive. Investing in them can put you ahead in the long run. You can limit some of your risk with the help of commodity ETFs.
4. Start a Business
If you are providing products and services, you can keep up with inflation by adjusting your prices as necessary. The downside, though, is that customers may not be happy with your rising prices. However, with slight adjustments when it comes time to renegotiate, it should be possible to create a revenue stream that paces inflation. This can be a boon in a world where wages from “the man” are less likely to keep up with inflation. With a little help from the Internet, you can gain the advantages of working from home, while possibly staying ahead of inflation.
5. Lock in Higher Interest Rates on Cash Accounts
While this is not something that is likely to happen anytime really soon, it is still worth keeping an eye out for higher interest rates. One of the key reasons for CD laddering is so that you can take advantage of higher rates when they come around. Keep watch over the interest trends, and when you can, lock in higher interest rates on your cash.
6. Lock in Lower Fixed Rates on Debt
If you have debt, now is the time to pay it down. You can reduce the effects of inflation later by getting fixed rates on mortgage loans and car loans. With rates as low as they are, you might consider refinancing. And, while you are about it, now is a good time to pay down high interest credit card debt, while more of your payment goes to principal.
What other ways can you think of to beat inflation?