There are situations where fear can serve you well. If you are driving in heavy fog and low visibility, fear will tell you to slow down. If you are at the top of a mountain on your skis, looking down at a slope that is far beyond your ability, fear will tell you to find a gentler path.
However, fear is not a good guide when it comes to your finances. Reacting in fear to financial markets tends to create overreactions, resulting in unnecessary losses and missing out on recovery gains.
Knowledge is Power: Don’t Fear the Effects of Inflation
Inflation has been a hot topic in the news. Whether price increases are temporary and due to COVID-related supply chain issues and pent-up funds or part of a longer-lasting issue, it’s an excellent time to understand what inflation is and how it impacts your finances.
Every economic condition offers investment opportunities, and some market sectors continue to perform well during inflationary periods. Market volatility can be unpleasant, but it’s good to know that the most significant stock market gains often follow the biggest losses.
If you have a solid, diversified investment strategy appropriate to your life stage, the best thing you can do is remain calm. Discuss your options with your CERTIFIED FINANCIAL PLANNER™ in the D.C. area before making changes. On-paper declines aren’t losses unless you sell.
Common Effects of Inflation
Inflation has been studied for decades. Its impact on economies and societies is well-researched. U.S. monetary policymakers aim for a healthy inflation rate of around 2% because this rate of steady growth keeps consumers active and businesses profitable.
The potential effects of inflation listed below are for rates that are notably higher than 2% if sustained over an extended period.
1. Decreases Purchasing Power
The most visible impact of inflation is a loss of purchasing power. As prices rise, the amount of goods and services you can trade for each dollar decreases. A fixed income will not stretch as far.
This trend has more impact on some consumers and businesses than others. People whose wages rise in step with inflation or a business that can pass on its extra expenses are less affected.
2. Encourages Consumer Spending
As prices rise, consumers tend to stock up on items with longer shelf life or jump on upgrades and improvements they may have otherwise delayed. For example, someone who was waiting to get a new TV or washing machine may decide to get it now before they’ll have to pay more for the same items.
The secondary result of increased consumer spending is that household savings tend to decline. Consumers don’t see the value of holding on to cash while it’s losing value. However, there are investments you can use to protect your cash during inflation.
You don’t want to let inflation, or fears about it, impact your retirement savings or long-term goals unnecessarily.
3. Higher Asset Prices
Tangible assets have historically held their value during inflationary periods. They include:
- Real estate
- Commodities (such as oil, lumber, and steel)
- Precious metals (like gold)
However, each of these assets has potential downside risks as well. Real estate is subject to property tax increases. Commodities are subject to demand and can be volatile. Precious metals may only keep up with inflation in the very long term.
For these reasons, it’s wise to consult your financial advisor in the D.C. area before adjusting your portfolio holding.
4. Makes Debt Repayment Easier
If you’re paying a mortgage, car loan, or business loan, inflation lets you repay your debt with dollars that are worth less than when you took the loan. This is most helpful to borrowers with fixed-interest rate loans.
For example, if your monthly car payment is $550 and the annual inflation rate is 7%, the $550 payment you’re making today is equivalent to $585 in last year’s money. The dollar amount of your payment remains constant but the value the lender is receiving goes down.
5. Historically Lower Levels of Unemployment
Historical trends show an inverse relationship between inflation and unemployment. During times of very low inflation or deflation, unemployment numbers climb. On the other hand, higher inflation corresponds with lower levels of unemployment.
While this may seem counterintuitive at first glance, inflation can be coupled with higher demand. An increase in demand pushes businesses to hire more workers.
6. Higher Interest Rates
While existing fixed-interest loans are easier to pay off during inflation, new loans can get more expensive. There are a few reasons interest rates can rise during inflation. It’s one way the Fed can help slow down the economy and keep things in check.
Second, lenders find themselves making less money on existing loans and want to protect the value of their funds. The resulting increase impacts consumer decisions to purchase big-ticket items like automobiles and houses.
While rampant, out-of-control inflation can be devastating to a currency and an economy, a period of higher inflation yields as many opportunities as it does challenges. The key is to avoid reacting to the media and instead make informed decisions to serve your long-term goals.
At Brown | Miller Wealth Management, our team of professionals has over 90 years of combined experience. We’ve been through multiple market cycles and provide our clients with comprehensive wealth management. If you would like to discuss how personalized financial management can help you grow and preserve your wealth, schedule a time to speak with us today.