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What is Inflation

Written by Matt Benson, CFP®

We’ve been hearing more and more about inflation in the news these days. By no coincidence, we’ve also had many recent conversations with clients on this same topic. While the concept of inflation is somewhat straightforward, I thought it would make sense to expand on the topic and provide a little more context about what’s going on today. As I thought about the best way to approach it, my mind kept going to Jeopardy and Alex Trebek. So, at the risk of hearing that loud ‘wrong answer’ buzzer noise, let’s start with this simple question (or is it the answer?) – What is inflation?

Inflation is a lagging economic indicator measured by the Consumer Price Index (CPI). The CPI measures changes in the price level of a weighted average basket of consumer goods and services, such as transportation, food and medical care. The U.S. Bureau of Labor Statistics tracks this information and essentially reports the purchasing power of our dollar. Does a dollar today buy as much of a good or service as it did last year? The answer is no. With a 2020 year-end CPI number of 1.4, we can conclude that we need slightly more money today to buy the same good or service as a year ago. This change in CPI is one element that can signal upcoming adjustments to the inflation rate.

Inflation rates have not been in the double digits since the year I was born. I am not trying to take credit for calming things down since 1980, but for the past 40+ years inflation has been largely held in check. The reason for the relatively steady inflation rates is the topic of a much larger discussion, but it’s one of the primary roles of the Federal Reserve.

So why are we talking about inflation now? That answer is policy, both fiscal and monetary. We have taken unprecedented steps in dealing with this pandemic which has resulted in a dramatic rise in the money supply. It is up 25% from a year ago, which is a staggering number. When the Federal Reserve used the tools at its disposal to address the Financial Crisis in 2007-2009 a lot of that had to deal with greasing the financial wheels to get things moving again. The recent measures undertaken have sent cash directly to people and to businesses via Paycheck Protection Program (PPP) loans. If there is more money chasing the same amount of goods and services, inflation is the result.

What does this mean for you? The impact inflation has on your financial plan is driven by many unique factors. CPI is often used as a reference point for cost-of-living adjustments. Your pension or social security check may be indexed to keep your purchasing power. If you have a fixed pension and your dollar now is not going as far, is there a need to generate additional income? From an investment standpoint, there are assets that function well or even provide hedges against rising inflation. Where it makes sense for the individual, we utilize positions in commodities. As an asset class they have historically performed well in inflationary periods and have provided a valuable complement to a diversified portfolio. We also employ inflation-protected bonds and senior bank loans as part of our non-stock allocations where appropriate. Stocks themselves have historically outpaced inflation so revisiting the level of stock exposure you have can help allay potential concerns about future inflation.

Rest assured, our team is paying close attention to any inflation adjustments and how they may impact your plan. We’re ready with a variety of strategies and tools, should any changes need to be made. In the meantime, if you find yourself watching one of the new celebrity-hosted Jeopardy episodes, I trust you will now be able to answer with confidence any question relating to inflation.