Inflation Returns After Long Hiatus

Higher prices cause advanced planning strategies

Americans who should be enjoying a resurgent economy and low unemployment instead face worries over how they can cope with a new threat: the highest inflation rate in 40 years.

Inflation has drawn little attention in recent years as rates remained low. However, the Consumer Price Index increased by 7% during 2021, the highest 12-month increase since June 1982, according to the U.S. Bureau of Labor Statistics. Over the previous decade, the rate had fluctuated between 1.5% and 3.2%.

Over the past 18 months, the Federal Reserve Board has focused on spurring economic growth as the country recovered from the COVID-19 pandemic. When inflation began to climb in mid-2021, the Fed expressed optimism the increases were a “transitory” trend primarily caused by pandemic supply chain delays and higher consumer demand.

However, by the end of the year, the Federal Reserve shifted from recovery measures (such as buying bonds and slashing interest rates to almost zero) to aggressive inflation-fighting strategies. The Fed has signaled that by March, its board will approve the first of several incremental increases in the federal funds rate over coming years (which will also drive up short-term borrowing costs).

The funds rate has stood at .25% since March 2020 and the prime interest rate at 3.25%. The Fed currently projects it will increase the funds rate to 2.1% by the end of 2024, which means a prime rate of just over 5%. While most economists expect the U.S. inflation rate will decline to 3% by the end of 2022, Americans experiencing higher prices at grocery stores and gas stations remain concerned about the return of significant inflation following years of moderate rates – and about how to plan for the financial impact of potentially continued increases ahead.

“Inflation is real, and sound financial planning will always factor inflation into the overall strategy,” Rick Kent CFP®, ChFC, AIF®, CEO and founder of Alpharetta, Georgia-based Merit Financial Advisors, told Advisors Magazine. “Recognizing the true impact of inflation is quite eye-opening. Therefore, it is imperative that inflation be factored into one’s forward-looking financial strategy. Failing to do so would certainly be detrimental to the overall effectiveness of the plan.”

Higher inflation could be with us for a long time, according to Karen L. Asbra, CFP®, principal and chief operating Officer at Rappaport Reiches Capital Management, LLC, in Skokie, Illinois.

However, attempting to forecast future inflation and interest rates is challenging. Rather than making short-term changes based on predictions, Asbra said, a better approach is preparing for a variety of outcomes (including increased inflation risk) as part of a long-term financial strategy.

“Protecting client portfolios starts with fundamental planning,” she continued. “How much risk are they comfortable taking? What mix of cash, stocks, and bonds makes sense for their situation? Remember: stocks, as a growth asset, remain a terrific hedge against inflation, as companies generally can pass on increased costs to maintain their margins. Bond portfolios that are high quality and conservative in terms of maturities, including an allocation to Treasury Inflation-Protected Securities, make sense as well.” Make a Plan, Stick to It Kent said his first concern is for individuals who may be waiting to see how the financial picture plays out before they take action, as well as those who delay implementing a strategic financial plan for many other reasons.

“With the likelihood of rising inflation ever-increasing, it is critical that investors have a sound a financial plan in place to help them weather any potential storm, he said.”

Once a plan is in place, Kent added, it is critical for investors to remain steadfast and stick to that plan. Entering and exiting the market in attempts to time the market can wreak havoc on their finances, he added. A better approach is to formulate a long-term plan and make slight adjustments along the way if needed. Otherwise, allowing emotions to overrule logic and reason often brings a hasty decision to abandon the plan completely.

The first step investors should take to mitigate higher inflation and higher interest rates is “a no-brainer”, said Karen R. Keatley, MBA, CFA®, CFP®, principal and chief wealth management officer at Modera Wealth Management in Charlotte North Carolina. She recommends locking in current low mortgage rates before they go up.

“If clients have floating rate mortgages, now is a good time to lock in attractive long-term fixed rate loans,” Keatley said. “It might even make sense for a client who doesn’t have a mortgage to get one. Inflation favors borrowers because debt amounts remain fixed while asset values increase. It’s the ultimate inflation play.”

Compared with other asset classes, stocks perform extremely well as an inflation hedge, she added, as they provide increasing income over time. Historically, both stock prices and dividend income have grown much faster than the rate of inflation. Healthcare Inflation Plagues Retirees Rising prices are particularly damaging for retirees. Even before inflation began dominating the headlines in 2021, Keatley said, retirees had been challenged for several years by excess inflation in healthcare costs. In the past, the conventional wisdom was that a retired person’s investment portfolio should be “conservative” with a weighting toward bonds, she said.

Typical retirement date funds offered by retirement plans are structured to increase the percentage of bond investments versus stocks over time.

“A fixed income translates to declining purchasing power,” Keatley continued. “If higher inflation persists, the result of this prevalent advice could be catastrophic. For retirees, living with portfolios weighted toward bonds doesn’t sound ‘conservative’ to me. It sounds incredibly risky.”

The conventional wisdom traditionally measures investment risk in terms of volatility, she said. Since bond returns are relatively stable, they are normally considered a more conservative instrument than stocks.

“However, as advisors and planners, we need to re-frame our client conversations around risk,” Keatley added. “We should be talking about risk in terms of purchasing power over time. Your client isn’t taking his entire brokerage account to the grocery store: he just needs to be able to buy groceries – today and 30 years from now. Volatility doesn’t matter as much as people think.”

While persistent inflation remains possible, Asbra noted, her firm encourages clients to focus on what they can control. That means preparing for a range of risks – including potentially higher inflation – in their financial plans.