Inflation is a hot topic these days. The Federal Reserve Bank has said that it anticipates that the current elevated inflation levels will prove to be transitory — or not long-lasting. On the other hand, many in the financial community are afraid that we are headed into a longer period of high inflation. They are putting their money where their mouths are by adjusting their portfolios to reflect this risk. Therefore, investors are at odds as to whether or not we will experience significant inflation in the U.S. anytime soon.
What is “inflation”, and what does it mean for you? Inflation is defined as the decline of purchasing power of a given currency (in our case the U.S. Dollar) over a certain period of time. Inflation is usually expressed as the change in prices over a one-year period. One can express inflation over periods shorter than a year, but they are usually annualized, or treated as if the shorter-term inflation were to remain the same for a full year.
Effect on Purchasing Power
The estimated effect of the decline in purchasing power (and thus inflation) can be reflected in the increase of the price of a basket of selected goods and services in an economy over a period of time. The best known “basket” measurements in the U.S. are the Producer Price Index (PPI) and the Consumer Price Index (CPI). The PPI measures the average change over time of selling prices received by U.S. goods and service producers. This index is unique in that it is used to measure price change from the viewpoint of the seller. This contrasts with other measures, including the CPI. CPI and other inflation indexes measure price change from the perspective of the purchaser. Note that the sellers’ price to sell and purchasers’ price to buy may differ because of government subsidies, taxes, and the costs of distribution.
The occurrence of price inflation decreases the ability of individuals to pay for the goods and services they need or want. A basic illustration would be the following: If an individual employee’s earnings remain level, while the cost of goods and services increases (price inflation), then the employee will be forced to purchase fewer goods and services. Their purchasing power is diminished. As inflation drags on for a while, workers will have the time and an incentive to negotiate higher pay to afford the higher prices of goods and services. This is called wage inflation. This effect is only temporary as high wages will lead to higher-priced goods and services in the vicious inflation cycle of upward prices.
Many economists look at the purchasing power between the U.S. and foreign countries. The tool they use to compare between countries is called purchasing power parity (PPP). The PPP is effectively the comparison of a basket of goods in U.S. Dollars, and the same basket of goods in a foreign country in their currency. Therefore, the PPP is the currency exchange rate at which U.S. Dollars would have to convert to foreign currency to buy the exact same basket of goods in the foreign country. If the foreign currency appreciates versus the Dollar, goods imported from that country will cost more to buy in U.S. Dollars. It may also allow domestic producers to increase prices since the foreign alternative now costs more.
Effect on Saving, Investing, and Borrowing
For individual savers, they are likely to see that their holdings (savings) in cash will be worth less in the future than it is today. This negatively impacts savers putting their money into interest-bearing accounts as well as bondholders, who generally receive a fixed income from the bonds. The return on interest-bearing accounts will become less attractive in the face of higher inflation. The bonds will also become less attractive, but as a security will also lose value. Other investors are seeking the newer, higher rates of return and your bond only pays the lower, older rate. Investors may be willing to buy your bond, but only at a discount. Bond math shows that when interest rates go up, bond prices go down.
Reduced purchasing power also affects stock prices and the broader economy. The reason is that if inflation causes a significant decrease in purchasing power, and the cost of living goes up, it can lead to more cash-strapped consumers reducing their purchases of goods and services.
Not only is price inflation bad for purchasing goods as services (so long as your income stays the same), it also proves to be bad for creditors. That being said, the other side of the coin is that debtors benefit from inflation. This is because as prices go up, the value of the money borrowed decreases, so the debtor is effectively paying back less money (value) than borrowed, and the creditor is receiving less money (value) than they lent originally.
Investors will find out in the coming months if inflation is indeed temporary or persistent. As the world economies continue to open up following the past year’s lockdown, we will see if demand for goods and services continues to outpace supply. In the meantime, you can expect that there will be some volatility in the stock and bond markets as this debate plays out.
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Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.