Financial Advice

JUNE 2021 | APTOS LIFE JUNE 2021 | APTOS LIFE 1010

Why Does Inflation Matter?

Is inflation picking up, or just the expectation of inflation? Is inflation a bad thing? How does inflation affect me? These are just a few of the questions our clients have been asking recently, so we thought it would be a good time to talk about inflation in a little more detail.

What is Inflation?

as “too many dollars chasing too few goods.” The Fed, however, says they are more concerned about not doing enough to aid in the economic recovery, and right now they see any increase in inflation as being more of a short-term issue. You might be thinking, “Why do we want inflation at all?” Modest inflation is a sign of a healthy pandemic took hold last spring, Soren E. Croxall economy. If people the Fed slashed the target fed In its simplest definition, Financial Advice know that prices funds rate to near zero in an inflation is the rise in are going to rise in attempt to bolster the economy the average cost of goods the future, it spurs by encouraging borrowing and and services over time. Until recently, the Federal Reserve (“the Fed”) set a target inflation rate of 2%. However, in August 2020, it tweaked its stance to say that it would target an “average” inflation rate of 2% over the long run. Essentially the Fed is saying that they will allow inflation to creep above the 2% for a period of time to help ensure maximum employment before they will begin using some of the tools in their arsenal to bring inflation back down. With what has happened them to consume today versus waiting. This keeps supply and demand more in balance. If we enter a period of deflation (i.e., falling price levels) consumers are disincentivized to buy now because they believe prices will be cheaper in the future. This, in turn, cuts into businesses’ bottom lines, as they aren’t selling as much (or eventually having to sell their goods at a lower price), which means they must cut costs (i.e., payroll) to stay afloat. This is not a good cycle. On the flip side, what about runaway inflation increasing the money supply. as a result of the pandemic, the (such as existed in the 1970s)? Fed wants to ensure that the Also not good as consumers buy economy has enough time to now (because they believe prices recover and that the labor market, will increase rapidly) which can which fell into a deep hole last create the illusion of demand and year, has ample time to recover. businesses in turn continue to Being too aggressive to address increase their prices in response. rising inflation too early in an The main tool that the Fed has economic recovery could backfire. at its disposal to control inflation

The current concern among is to increase the federal funds economists is that the amount rate, which is the rate banks of fiscal stimulus being pumped charge to borrow from each other. into the economy, coupled with Doing this discourages borrowing the reopening and loosening of by effectively causing shorthealth measures, could cause a term interest rates to increase, rapid increase in demand that and leads to potential delays outstrips supply, which could in consumption. In theory, this cause the economy to overheat, should slow down the economy thus leading to persistently higher and thus cause inflation to inflation. This is often referred to hold steady or fall. When the

If inflation grows too much and incomes or investments returns don’t keep up, you lose purchasing power over time.

How Inflation Affects You

If inflation grows too much and incomes or investments returns don’t keep up, you lose purchasing power over time. For example, if you earn next to nothing in your bank account, but inflation is 2%, you haven’t been able to keep up with inflation, and thus your cash doesn’t go as far as it used to.

For investments, the effects of inflation can be most directly seen with fixed income (bond) holdings. If you own a plain vanilla bond as an example, you receive a fixed interest payment, called a coupon, over a specified period of time. However, if prices start to increase due to inflation and you continue to receive the same fixed interest payment, your purchasing power has been eroded. Rising inflation can also potentially have an adverse effect on the value of bonds for bondholders who plan to sell their bonds prior to maturity. For stocks, the relationship with inflation is somewhat more indirect. For companies that have a lot of control over pricing, they may be able to increase the price of their goods as inflation increases which may lead to higher earnings. However, companies that aren’t able to pass on price increases as easily to the end consumer may not fare as well during periods of increased inflation.

Inflation is a definite factor investors need to consider when they design and implement their overall investment portfolio. Planning for a long retirement means attempting to maintain the same standard of living you currently enjoy. Not keeping up with inflation will simply reduce your real “purchasing power” over time. Portfolios don’t need to necessarily be 100% inflation sensitive, but they should be diversified enough to have an opportunity to potentially outpace inflation over time and achieve “real growth.”

Soren Croxall, CFA, CFP® is a registered representative of LPL Financial Securities and Advisory Services offered through LPL Financial, member FINRA/SIPC, a Registered Investment Advisor. LPL Financial and Croxall Capital Planning do not provide tax or legal advice. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.