Stop ignoring the inflation elephant in the room

Stop ignoring the inflation elephant in the room
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Put a frog in boiling water and it will instinctively jump out. Put a frog in tepid water and slowly increase the heat to a boil, and it will not perceive the danger and in turn be cooked to death.

At least that’s the premise for a late 19th-century fable that serves as a metaphor for our inability and unwillingness to react or be aware of threats that arise gradually. That subtle threat regarding our money at present is none other than inflation. 

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How significant is inflation? Remember that time as a kid when you asked your grandfather to buy you a Snickers bar and he nostalgically replied that a candy bar only cost him a nickel back in his day? Or think back to the first job you had, do you remember your hourly wage?

 

You see, in hindsight inflation is easy to spot, but in the heat of the moment, we often find ourselves as oblivious to the rising temperatures as an amphibian. 

Nearly a decade beyond the financial crisis, equities have increased over 300 percent from their March 2009 bottom. This historic bull market has been aided in part by multiple rounds of quantitative easing (QE). So let’s start there, what is quantitative easing?

Simply put, it is a massive expansion of the open market operations of the central bank. It adds liquidity to the capital markets, which is used to stimulate the economy by making it easier for businesses to borrow money.

Because our economy operates on “supply and demand” this increase in the money supply spawns low interest rates — as evidenced by the past decade. 

Fast forward to the present, where economic metrics such as unemployment rates and GDP growth point positive. You likely need not look further than your 401(k) statement to see the glowing impact of QE. Unfortunately, that effective short-term catalyst doesn’t come absent of unwanted side-effects.

When the Federal Reserve started “printing money” to execute the stimulus, they were using a unique power the central bank has to create the credit needed to purchase these assets out of thin air.

Fed Governor Randal Quarles recently said, “It has been quite some time” since the economy has looked this good. In light of that growth, he also indicated that rate hikes are likely, with many anticipating three increases this year.

So what does anecdotal jargon about rising interest rates and inflation practically mean for you and your money? Here are 3 personal finance tips to consider: 

Avoid long-term bonds 

Rising interest rates mean falling bond prices. However not all fixed-income investments are created equal. The longer until a bond matures, the more drastic the decline will be as rates increase. For many, the plan to mitigate this “interest rate risk” consists of simply avoiding the urge to sell bonds on the secondary market at a loss.

However, this is often nothing more than an example of “jumping out of the frying pan and into fire." Historically, your money has to double every 20-25 years to simply keep up with inflation.

Therefore, you will likely find yourself disappointed by the purchasing power of your original investment when the principal is finally returned at maturity — assuming you avoid “default risk” of course.

Avoid long-term CDs

This should be intuitive. If inflation is occurring and interest rates are rising, then there should be little logic found in “locking up” your hard-earned savings at suspected lower rates than what will soon be available.

If you are adamant about owning CDs in a rising-interest-rate environment, a laddering approach may be prudent. Even so, staying short-term with maturity dates is advised as an approach to avoid the similar purchasing power constraints outlined above. 

Broadly diversify 

If you have a long-time horizon, it is likely that your asset allocation consists of equities. Inflation can have a relatively benign impact on your portfolio, assuming you maintain financial discipline during times of market fluctuations while possessing adequate cash reserves to cover short-term needs — using history as our proxy.

This acknowledges that companies reserve their right to increase costs on goods and services in an effort to preserve proportional profits during inflationary environments. As a partial owner, you in turn benefit from those profits by way of potential share-price appreciation.

If you are nearing or entering retirement and want a more predictable short-term approach, it may still be prudent to diversify a portion of your portfolio into equities as a complement to your more stable asset categories.

Although increasing equities to decrease risk may seem counterintuitive, it may be one of the most effective adjustments to make as inflation takes flight.

Regardless of your personal situation, it’s no longer time to ignore that the water temperature is rising.

John Hagensen is the founder and managing director of Keystone Wealth Partners, LLC, which offers wealth management and investment management services.