Filenews 19 April 2022
By Allison Schrager
If you are under the age of 45 and live in America or Europe, chances are that last year was your first real life experience with inflation. Apart from a mini-surge in 2008, inflation has barely exceeded an average of 3% over the past 30 years.
But now inflation has returned. The relative index recorded an increase of more than 8% last month and may deteriorate further before retreating. Some of the factors of price increases today, such as supply chain disruptions and the war in Ukraine, will eventually leave the spotlight. There is reason to estimate that we will not immediately return to inflation of 2%. The economy is now different and the new "normal" for inflation will be close to 4% or even 5%.
Americans were doing quite well when higher inflation was the norm. But the world today is different. 4% entails new costs, but also benefits, for a new generation of people.
So what does it mean to live one's life or run your business with inflation ranging between 4% and 5% instead of the 1.5% to 2.5% that we have taken for granted for so long? In order to "paint" this image, we must proceed to the assumption of a reasonable degree of stability.
If inflation is higher, but remains in a limited range, it will not cause much damage. Average inflation has been between 4% and 5% for many years and the economy has continued to grow.
Annual Increases
That said, a lot has changed since the late 1980s, when inflation hovered around 4%.
This figure is almost double what the people of our time are used to and all parts of the economy will have to adapt. Receiving a salary increase was a less critical parameter when inflation was 1% or 2%. Employers have become accustomed to giving smaller increases.
The last time inflation was high, the unions negotiated annual increases adapted to the increase in the cost of living which were incorporated into the wages of many workers. Now most will need to demand such increases individually, each for himself. For workers who cannot negotiate increases that are in line with inflation, their real pay will shrink every year, as it will be worth practically less and less.
Even if you receive a decent increase, it generally comes only once a year, while inflation is a continuous/enduring phenomenon, which devours your purchasing power day by day.
Business impact
Companies will not do it easily either. They will have to deal with higher labour, rent and goods costs that they use. They will need to raise their prices more often, which risks alienating many of their customers. It puts smaller businesses at a disadvantage, shifting demand to large companies with larger profit margins, which can afford to absorb some of the inflation in order to transfer less of the 'pain' to the consumer.
Inflation will be a bigger problem for small businesses than it was in the 1980s, because large companies now dominate the market - most likely it is that the local home equipment store in the US is already making it very difficult to make ends meet with Home Depot. The online market, which has reduced prices by increasing transparency, will continue to make it difficult to raise prices above those of competitors, which will be another blow against small companies.
Housing
Interest rates will rise because the Fed will raise its key interest rates in order to keep inflation under control and investors will require higher interest rates to offset inflation. This will mean more expensive mortgages.
This would normally weaken house prices, however, as long as demand exceeds supply - as we are seeing today - and to the extent that the rental market continues to flourish, one cannot bet on falling house prices.
However, if you already own a house with a fixed-rate mortgage loan, your earnings will increase, while the monthly payment of your home loan will remain the same, which means that your actual housing costs will decrease (although the same is not true for property ownership taxes or maintenance costs).
The savings strategy
Savings and investing will also become more demanding processes. Right now, banks basically pay about zero interest on your savings. If inflation rises, they will pay a little more interest, but don't expect the 8% interest rates paid to depositors in the 1980s. Banks need retail banking less than in the 1980s, so they will most likely be less inclined to raise interest rates to attract customers to open new accounts.
Government bonds offer another low-risk investment option and their yields will rise as well. They may not, however, increase enough to offset inflation because, compared to the 1980s, safe assets are still in high demand from foreign governments and banks for regulatory reasons. Therefore, if you want to protect your savings from inflation, you should invest in higher-risk assets.
So, if you are pushed from the situation to more "dangerous" assets, diversification is the key. Holding many different shares reduces risk without diminishing the expected return. The easiest and cheapest way to gain risk exposure, along with diversification, is to buy a simple, broad fund linked to a stock market index, such as the S&P 500. Or, if you want even more diversification, choose a fund with exposure to shares from all over the world. These investments are a good counterpart to inflation, they are well diversified and very liquid, so you can sell if you need cash.
If you want more risk and more diversification, you can include in your package a commodities fund or a bond fund that includes corporate or municipal bonds. The key is to find funds that charge low commissions, provide liquidity and include as many types of securities as possible.
Real estate is also considered a good counterpart to inflation, however it is less liquid and has higher charges, so it is a less good option unless you plan to own it for a long time.
Pension plan
Pensioners with private schemes are usually the most affected by inflation because they live on a stable income. The good news is that social security is adjusting to inflation.
However, when inflation was low, some pension plans cut their adjustments to the cost of living, which did not seem so important at the time. With inflation at 4% or 5%, however, pensioners will "feel" the loss.
Many of them are encouraged to invest in short-term government bonds as they age, in order to protect themselves from the risk of market ups and downs. However, if these bonds do not ultimately keep up with inflation - and will probably not go hand in hand - people will feel pressured to keep a larger portion of their security savings in higher-risk assets. This could make their income and their ability to spend much less predictable.
A "sunbeam" for debt
Higher inflation will also have some benefits, especially if you have more debts than savings, as your income will logically increase, while the amount of your loans will remain stable, so you have more money to make payments or repay them in total. This will be a benefit for those who owe student loans, but also for homeowners with fixed-rate mortgages.
So, if we get to the period of higher, but relatively stable inflation, Americans will most likely experience an awkward period of adjustment by learning to live with rising prices in grocery stores, restaurants, and anywhere else we're used to a fixed cost of living.
However, the economy more broadly and our personal finances will adapt as price increases flow and wages follow. Although inflation of 4% is not what it once was, this is a new economy and we should all adapt the way we invest and develop a strategy of defence against inflation.
Surely, however, it will be a long time before one feels complacency in the face of inflation again.
Source: BloombergOpinion
