When I write articles, I try to keep them as timeless as possible. At the time of writing this article in Nov 2021, inflation is a hot topic and everyone seems really worried and scared about it. This article is meant to be a quick hit to introduce inflation and why you should or should not be worried about it.
What does inflation mean?
I don’t like to assume anything so I want to start with the basics. Inflation means two things fundamentally – one, prices of all or most goods across the economy are going up and two, as a result, the purchasing power of your money is going down. I will talk about the latter in more detail later. There are a variety of reasons why prices in the economy go up and I won’t go into that here. The opposite of inflation is deflation which has not really occurred in recent times in US history.
Why should I care about inflation?
Simply put, as I mentioned above, your dollars (or whatever currency you have) lose value every year when there is inflation. If you own $1 today and inflation is 10% during the year, by the end of the year, the value of that $1 is only 90 cents. In practical terms, it simply means you can buy a lot less for $1 compared to the prior year. So unless your income is increasing by at least inflation or more, you are losing money each year – or at least saving a lot less money each year.
So is inflation one number across everything I buy?
Not really. We all know the cost of different types of goods and services change in different ways. Some goods or services will go up more than the other. Inflation in the US is traditionally measured by the CPI (Consumer Price Index) produced by the Bureau of Labor Statistics. you.
The US Federal Reserve’s preferred method of looking at inflation though is the Core Personal Consumption Expenditures index (PCE) . At the time of writing this article the average CPI % change YOY for the last 12 months is around 6.2% and the average change in PCE is around 4.4%. Why are they different? They just use different methods to calculate it. CPI is based on a survey of a sample of households whereas PCE is a broad aggregation of GDP data. The reason inflation has become so topical is because these numbers are much higher than what they have been for many years in the last decade. While we have had a month or two of higher inflation during some years, this year, the increases seem persistent over a longer period of time.
Is inflation a bad thing?
In general, for many years during the last decade, people were not really thinking much about inflation when it was at a rate of below 2%. Now, in 2021 everyone is worried about it because it is much higher. In general though inflation is a normal thing. All of us would like to get paid more each year and see increases in our income. That’s a natural part of the process. Inflation in general means the overall GDP (Gross Domestic Product) is going up so in general it is a good thing. But, when it goes above a certain level, then it can cause more harm. The US Federal Reserve has had a target of maintaining inflation at an average of 2% over time. When they see inflation at a rate higher or lower over a long period consistently, they like to step in and take corrective actions (monetary policy is out of scope of this article so I wont go into details here).
What is my personal rate of inflation?
But the above indices are average numbers and do not reflect the reality for every single person. The CPI and PCEs are simply an indication of the broad movement in the economy. You will need to assess how it impacts you personally. Energy prices are at all time high but if you are someone who does not drive a lot and dont use natural gas a lot then you are likely not going to be impacted heavily. The vice versa is also true. Rents are increasing significantly but if you are a home owner with a fixed mortgage, you are not impacted by that. But everyone is likely being impacted by increasing food prices. But if you are someone who eats out at restaurants a lot, you will see a bigger impact compared to someone who cooks and eats at home more. This is because in today’s context, labor has become expensive. So the only way to really know your personal rate of inflation is to look at your monthly expenses and compare it to certain time periods.
How do I protect myself against inflation then?
We are in an interesting time where inflation is high but interest rates are still relatively low. So parking money in a savings account or a CD is just not going to cut it (outside of your emergency fund which you always want to keep that liquid even if its at a super low interest rate). So below are some common places to invest to see your money grow at a rate higher than inflation (this is not an exhaustive list by many means simply some common ones):
- Stocks: While everyone seems to be ploughing money into stocks since the market has been on a tear, it’s important not to get too carried away by that. That said – stocks in the long run are always a good bet to see growth above inflation. The S&P 500 index has grown approx 30%+ in the last 12 months but over the last 10 years has grown 18%+. There are a lot of folks who believe stocks have seen a huge extended bull run in the last decade and that’s going to change. But in the long run, stocks are still a good bet as long as you are well diversified. Remember, there is risk in stocks.
- TIPS (Treasury Inflation Protected Securities): For those who are looking for less risky or pretty much no risk ways to save, TIPS are a good option but yields are much lower than stocks for eg. The principal of a TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index.
- I-Bonds: not too many people have heard of this. These are also sold by the US Treasury and carry almost no risk and as of writing this article carry 7.12% interest!! But that rate gets adjusted every 6 months based on the inflation rate. The catch is each individual person can only invest a max of $10,000.
- Real Estate – this is one of my favorites and in my opinion when you buy investment real estate at a 15 or 30 year fixed mortgage, you see your expenses stay flat and are a great inflation hedge. Rents will rise typically with inflation as well. Property taxes dont typically tend to rise at the rate of inflation. As I have mentioned in my articles, if you do this right, you can earn decent returns that can be a good bond type portfolio.
- Gold and crypto currencies – gold has been considered the traditional hedge against inflation though in my opinion has not held up well in the long run. Cryptocurrencies like Bitcoin and Ethereum are extremely volatile and as I have mentioned in prior articles, you should limit your exposure to these. These have a lot less history for us to know what will happen through the cycles.
One final comment on this – as you assess ways to ensure your money keeps up or beats inflation, be fully aware of the risks. Dont unnecessarily add risk to your portfolio simply because you are worried about inflation. You can do all of the above with minimal risk.
Concluding comments
Be very aware of inflation. Its important to know your expenditure side of inflation to understand how your costs are going up. But on the other hand, be also aware of how much your income (W2 or wages, passive income) are going up. Ensure that they not only keep up with inflation but also exceed it. But as you do that, ensure you keep your risk profile in mind.
Thank you for reading. I wish you success in your personal finance journey!
Disclaimer: I am not a financial advisor and all the information in my articles are from my personal experience and are for informational and educational purposes only. Please consult with a financial advisor or CPA for professional advice.
