Why inflation is both good and bad for your wallet
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Inflation is here and higher interest rates could ensue – much to the delight of savers who have endured very low returns on cash and other safe investments since the Great Recession.
But inflation is a double-edged sword. The higher prices that consumers pay for goods and services can completely swallow up their additional savings.
“It’s one of those things where interest rates give in with one hand and inflation wins with the other,” said Christine Benz, director of personal finance at Morningstar.
Consumer prices jumped 4.2% in April from a year earlier, the biggest increase since 2008.
On the one hand, this acceleration makes sense – a year ago the Covid pandemic caused the US economy to flare up and inflation was low. With the threat of Covid diminishing, consumer demand (along with some supply shortages) is pushing up prices in some sectors.
But it is not known if the dynamic is temporary or something more permanent.
The latter would generally lead the Federal Reserve to raise interest rates, in order to increase borrowing costs and hopefully prevent the economy from overheating.
Rates on savings accounts, money market funds and certificates of deposit, for example, would likely increase – instead of being the equivalent of “mattress money” with virtually no return, according to Diahann Lassus, Senior Director of Peapack Private Wealth Management in New Providence, New Jersey.
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However, consumers could channel those returns to living expenses like rent, food, transportation and health insurance if they inflate in prices, she said.
Indeed, some companies have recently increased the prices of household items like toilet paper, peanut butter and soft drinks.
“All of these things obviously have a major impact,” said Lassus, financial planner and chartered accountant.
There have been a few times in history where savers have achieved a negative net return after accounting for inflation.
In 1980, for example, a benchmark 10-year Treasury bond had an average yield of 11.43%, one of the highest on record. (This return exceeds the average annualized return by approximately 10% of stocks, as measured by the S&P 500 Index.)
However, an inflation rate of 13.5% in 1980 more than offset these windfall gains, causing a loss of around 2%.
And that’s before tax. If Uncle Sam took a third of the profits, the investor would have lost nearly 6% of his purchasing power, according to Allan Roth, CFP and accountant at Wealth Logic in Colorado Springs, Colorado.
“The purpose of the portfolio is to give you choices in life,” said Roth. “And inflation and taxes eat away at those choices.”
In fact, an environment of low inflation and low interest rates (like pre-pandemic dynamics) is optimal for consumers from a tax standpoint, Roth said. That’s because the U.S. tax system is based on nominal (rather than net) investment returns, he said.
A few caveats
Of course, there are a few caveats. If inflation turns out to be temporary, as some officials predict, the Fed may not be raising interest rates anytime soon.
“It is unlikely that a limited period of price increases linked to the pandemic will permanently change the dynamics of inflation,” Federal Reserve Governor Lael Brainard said in a speech last month.
And market expectations for inflation, rather than Fed policy, have a greater bearing on investments like the 10-year Treasury with a longer time horizon, financial advisers say.
Moreover, inflation does not necessarily have an equal impact on all goods and services. Some consumers may be more affected than others.
Winners and losers
If inflation is here to stay, however, there will be winners and losers.
“If you owe money, inflation is a very good thing,” Roth said of consumers with loans. “If people owe you money, inflation is a bad thing.”
For example, a bond is essentially an IOU with interest. Someone who holds a low-interest bond or CD with a 10-year (or more) time horizon may end up with a paltry return and look aside as other investors venture into long-term bonds. higher yield.
On the other hand, a homeowner who has locked in a fixed mortgage at a low interest rate is in a good position – their home’s value would likely inflate, but their monthly loan payments would stay the same.
“It’s kind of a ray of sunshine for those who own a home,” Lassus said.
Rising inflation can also be a challenge for seniors, especially those with a fixed budget and who derive most of their income from investments. A positive point: those who draw most of their income from Social Security are well placed, because these monthly payments increase with the cost of living.
Americans who are still working may also receive a cost of living increase on their paycheck to reflect rising prices, Benz said.
Compared to investments, bond mutual funds and exchange-traded funds offer some additional flexibility, according to Lassus. Holding individual bonds, especially those with maturities longer than seven years, is probably not a good idea for investors worried about inflation, she added.
Allocating maybe 5% to 10% of her bond portfolio to inflation-protected Treasury securities, known as TIPS, also offers inflation hedge, she said.
Equity funds don’t offer a direct hedge against inflation, but have historically outperformed inflation by a comfortable margin over the long term, Benz said.