Dealing with inflation

Dealing with inflation

April 11, 2022

Last week, I wrote about Paul Volcker’s battle to curb inflation more than 40 years ago. It took three years of relentless effort, and many more years of ongoing vigilance, but the Volcker Fed finally beat inflation. Unfortunately, Jerome Powell’s Fed is not following suit. The fact that they continued their massive quantitative easing long after inflation surged was disappointing. Perhaps even worse, their initial response to inflation—a tepid mix of jawboning (i.e., trying to talk inflation down) and modest incremental increases in short-term interest rates—is the same approach the Fed took in the 1970s before Paul Volcker. It didn’t work then, and I doubt it will work now. Unless the Fed gets more aggressive, inflation may be with us for a while.

During inflation, the cost of living often moves up faster than income, which can crowd out the capacity to add to long-term savings. This can be disastrous for retirement. Consider the case of a 40-year-old trying to save for retirement. A dollar saved today and invested to earn an annual compounded return of 7 percent would grow to be $5.43 in 25 years. If inflation keeps you from saving, your retirement could be seriously impaired.

To prevent this, you may need to make some changes in your spending habits. For example, do you commute to work as a solo driver? Maybe now is the time to start a carpool with your coworkers or friends. How fast are you driving? Slowing down to 55 will save lives and gasoline. And maybe now is a good time to put on that extra sweater and turn down your thermostat while you sort your grocery coupons into little file boxes. If you are over 60 years old, you might be feeling a sense of déjà vu right now, or maybe a little dread. Those were some ways people coped with inflation in the 1970s. I’m sure they can help today, also.

Inflation not only makes life more expensive today, but it also reduces the buying power of your savings in the future. Even small amounts of inflation can cause big long-term problems. Suppose your desired standard of living today costs $100,000. If inflation averages 2 percent per year, that same standard of living will cost almost $122,000 in ten years. If inflation doubles to 4 percent per year, your standard of living will cost nearly $150,000 ten years from now. Unless your investments keep up with inflation, your standard of living in retirement will take a significant hit.

Inflation turns the traditional “safe” versus “risky” investment conversation on its head. If I asked you to rank three investment options—cash, diversified bonds, and diversified stocks—from least risky to most risky over a five-year horizon, you would likely rank cash as least risky, stocks as most risky, with bonds somewhere in between. However, with annual inflation at 7.9 percent and cash investments yielding less than 1.0 percent, investing in cash “locks in” an annual loss, in real terms, of nearly 7 percent. Stocks, on the other hand, despite their volatility, offer the potential for a positive real return. In this case, stocks might be considered less risky than cash.

Determining which asset class provides the best protection from inflation has long been a matter of debate. Several studies have looked at the question, but those that I find most helpful recommend holding a mix of certain asset classes while avoiding others. Asset classes to hold include real estate, small cap growth stocks, large cap stocks, and inflation-protected bonds. Surprisingly, commodities do less well, because their volatility doesn’t serve them well during periods of moderate inflation. Asset classes to avoid include cash-like investments (i.e., money market funds, bank CDs, etc.) and regular bonds, especially long-term bonds.

Inflation also favors borrowers especially if they can borrow at a low, fixed rate of interest and with a long maturity. If that brings to mind a fixed-rate mortgage, you are on the right track. Borrowers get to repay their loans in the distant future using dollars that have lost their purchasing power because of inflation, while their home values increase with inflation. Borrowing money at an interest rate below the inflation rate is like the bank paying you to borrow the money. It’s hard not to like that.

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 about investments, taxes, retirement, or estate planning. Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA 93940 or email them to