How real is the possibility of inflation? What steps can you take if it takes hold?
Inflation in the United States has been accelerating no matter how hard you try and avoid looking at it. Last week, the key metric followed by the Federal Reserve to measure the fluctuation in prices within the economy– the Core PCE Price Index — showed a 0.6% monthly increase during May while accumulating an annual jump of 3.4%.
Meanwhile, other readings such as the more popular CPI Index reported a 5% annual variation by the end of May and the Core CPI, which excludes food and energy prices, experienced a 3.8% annual jump.
These numbers are among the highest in decades and are starting to get scary as the prospect of a prolonged deterioration in the purchasing power of the US dollar seems to be a looming threat.
For now, officials from the Federal Reserve have deemed these higher inflation readings as “transitory” due to the impact of supply shortages caused by the pandemic and a lower comparative baseline as prices went down sharply around this time last year amid anemic demand during lockdowns.
So, is the threat of persistently higher inflation readings as real as it seems or not?
Liquidity, velocity, and other influencing factors
Analyzing the dynamics that are pushing the price of goods and services higher in today’s complex globalized economy is not an easy task. There are many factors to consider, and they each have their fair share of influence on how prices fluctuate in the United States.
To start with, it is important to note that the pandemic did strike a strong blow on prices during the first two quarters of 2020. The chart above from the Federal Reserve shows that in both March and April last year, the Core PCE Index experienced a 0.1% and 0.4% decline respectively during the worst days of pandemic lockdowns. To put that into context, the April drop has been the second worst in history, only preceded by the 0.6% drop seen in September 2001.
After that, the situation started to improve for the economy as the government quickly stepped up to provide funds for households and businesses through fiscal and monetary stimuli, resulting in trillions of dollars injected into the economy at a point when it was badly needed.
Those measures were convenient and justified based on the overly negative backdrop, but they have also led to a significant jump in the country’s overall liquidity, with nearly 20% of all the US dollars printed in history being issued last year.
The problem with that is that as the economy bounces back from the pandemic, those dollars will likely put pressure on prices as there will be more dollars chasing a similar number of goods and services.
Meanwhile, even though banks have not yet relaxed their conditions to extend credit, they are finding themselves increasingly forced to do so as they are sitting on billions in excess cash reserves that are currently unproductive.
If banks start to relax their credit conditions once the economy gets betters, that will multiply the impact of the money flowing within the economy — a phenomenon that is measured by an indicator known as money velocity.
For now, M2 money velocity is contained as shown in the chart above. However, if it starts to tick higher, chances are that inflation will not be as transitory as government officials might be expecting.
The impact of higher inflation for Main Street
How does higher inflation affect the average American? Higher inflationary pressures have a clear impact on everybody’s pockets as salaries will not immediately chase prices higher, which results in a real deterioration in the purchasing power of the dollar.
Moreover, the gains seen by assets such as stocks, bonds, and real estate will be lower in real terms, meaning after deducting inflation. Even though some assets will be positively affected by higher prices, which would result in higher corporate earnings, inflation will eat into a portion of those gains.
After everything is said and done, we need to recognize that the threat of prolonged elevated inflation levels in the United States is real, and that Americans should brace for a period where the dollar might lose some of its purchasing power unless government officials recognize this reality and act promptly to correct it.
Inflation is not due to random chance. The conditions are ripe for a loss in the dollar’s buying power and people should hedge against such forces.
1. Reallocate investments into stocks
Bonds tend to take a hit during times of inflation so putting 15–20% of your portfolio into relatively safe stocks (low Beta) will help you ride the inflation wave.
2. Watch real estate
The insanely hot real estate market is showing signs of cooling off. Even so, real estate investments, or REITs (real estate investment trusts) are diversified enough among the different categories of real estate to keep your nest egg from being watered down.
3. Treasury inflation-protected securities (TIPS)
These are Unites States government bonds that are indexed to inflation. This means that as the CPI rises, the bond also pays more.
4. Goldilocks Principle: Just right
Don’t lost your head but don’t do nothing. Don’t buy all gold, buy a ton of real estate, or sit back on a bunch of cash. Make small changes, many times under 10% of your nest egg, in several directions, such as those mentioned above. Inflation does come and go, but radical changes on your part that lead to losses may be harder to overcome.
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NOTE: This article is meant to be used for informational purposes and is not intended as financial advice. Please consult a qualified financial advisor before making any changes to your accounts.