What’s up with inflation?

Steve Merrell |

Q: I’ve read several articles recently about the possibility of rising inflation. Some suggest that current economic policies are setting us up for serious problems in the next several years. Is this really something to worry about? The COLA (cost of living adjustment) for my Social Security has been very low for a long time. If inflation is a problem, how do I protect myself?

A: Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in ouput.”

I know that’s a real mouthful. Let me see if I can break it down a little.

Friedman’s basic idea is that inflation is caused by the amount of money in an economy relative to the supply of goods and services the economy is producing. If the supply of money increases faster than the supply of goods and services, you get inflation.

If you believe Friedman’s theory of inflation, it is easy to see why some people might be feeling nervous. Since the pandemic started, the Federal Reserve has pumped nearly $1.5 trillion into the economy through their monthly bond purchases. In addition, various other programs added money into the system. The largest and most visible was the Payroll Protection Program which issued up to $669 billion in loans, all of which could be totally forgiven. That means well over $2 trillion of liquidity has flowed into the economy over the past 12 months—a time when economic output was artificially limited because of the COVID shutdown.

With all that liquidity hitting the economy, some people might wonder why we haven’t seen more inflation. There are at least two answers to that question. The first is that we have seen inflation. In fact, we have seen a lot of it, but mostly in asset prices. In the past 12 months, U.S. stock prices have risen 21 percent with some stocks rising many multiples of that. Amazon (+76%), Apple (+82%), and Tesla (+754%) are three dramatic examples. The stock market’s performance is remarkable when you consider that U.S. economic output actually shrank by more than 2 percent during the same time period.

The second answer is that inflation pressures usually take a while to show up in the general price data. At this point we should be looking for early warning signs that an inflationary surge is building somewhere in the economic pipeline. It is hard to know for sure, but we might be starting to see the first stirrings of inflation in the commodity sector. For example, industrial commodity prices have risen 13 percent over the past year and are now at their highest level since July 2008. Part of this increase comes from the volatile fuels sector, but other commodity prices have been rising too, most notably zinc (+55%) and copper (+56%). To be clear, these are narrow little sectors, but investors are starting to take notice.

Whether there is a major inflation problem brewing or not, it is important to protect your savings from the effects of inflation. Inflation is like financial cancer and even small amounts of inflation can significantly reduce your buying power over time. Recent history illustrates what I mean. Since 2010, the Consumer Price Index has risen at a paltry 1.75 percent per year. However, even that modest inflation would have reduced the purchasing power of your savings by nearly 18 percent if you didn’t protect against it somehow.

The best way to protect against inflation is to invest your savings in a well-diversified portfolio of high-quality assets that will grow with inflation. Some people favor real estate, other people seem to like commodities. Personally, I prefer a portfolio heavily weighted toward stocks. Above all, you want to minimize your exposure to asset classes that are hurt by inflation. These include cash and bonds that pay a fixed interest rate. If you need to hold bonds, try to find inflation-protected bonds or bonds with floating interest rates. 

 

 

Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to smerrell@montereypw.com.