The inflation we’re facing nowadays is a scary thing. Not only is it something we haven’t dealt with as Americans since several decades ago, but we’re kind of in a rock and a hard place with the choices the Fed can implement to deal with it.
However, there are things we can learn and do ourselves to minimize the impact inflation has on our portfolios. This is especially important as you near retirement, as unexpected chaos in the economy and the markets can often lead us to make rash decisions. In this post, we’ll be talking about the impact that inflation has on portfolios and what you can do to hedge against inflation through your portfolios.
Inflation: Why do we care?
Gas, Airbnb, construction of new homes, and simply eating are getting way expensive. The prices going up in and of itself isn’t necessarily a problem. It’s when you couple it with a stagnant wage that it becomes problematic. It affects the lower and middle classes much more disproportionately than the upper class. For the upper class, it may mean going to a restaurant 6 days out of the week instead of 7, maybe. But for your average working Joe, it may mean eating a full meal 6 days instead of 7 for the week. It makes an already strained budget that much more difficult to juggle.
Inflation also affects people’s retirement savings. When you plan for retirement, you’re betting on a certain cost of living, and if the cost-of-living skyrockets right as you’re entering retirement, you might suddenly not have enough to make it work. Not to mention the effect it has on your portfolio.
You might have a mixture of stocks and bonds in your portfolio. The majority of investors do. Both of these are losing value, which sucks since bonds were supposed to act as a hedge for your equity holdings.
Whatever your situation, don’t panic, we will help you through these hard times, the most important thing is to stay calm.
Also check out 7 tips to combat rising costs of living.
What sucks during inflationary times?
Cash – during inflation, cash is constantly losing value. Your purchasing power declines. Restaurants used to ask you for $7 for a meal. Now they’re asking for $10 for the same meal. Don’t even get me started on increased tip expectations.
Bonds – we’re talking specifically about fixed-income bonds. You buy a bond, and you get a 3% yield every year. Whereas you planned to live on 3% of your portfolio each year as income, now you can’t because inflation made it so that everything costs 5% of your portfolio instead. Unfortunately, it has no chance to increase, because at the price you bought it at, you agreed to the fixed yield you get at the time.
Stocks – this is a tricky one and not as straightforward as one might think. Stocks generally are able to take inflation into account. When cost of raw materials goes up, they increase their prices to make up for it. However, it’s very individualized by the stock in question.
Additionally, the stock market also reacts quite violently to news of potential rate hikes, actual rate hikes, anticipation of a recession, etc. So, while stocks might even possibly benefit for a while from inflation, you never know when they’ll tumble. It’s a complex situation with stocks, and often better left to the experts.
What the Fed can do to curb inflation?
We know that the Fed is implementing rate hikes to try and slow down inflation. However, they’re doing it carefully so as to try not to induce a recession while doing so. It’s debatable whether it’ll work or not. The stock market has been reacting very erratically to the hikes. But the question is, is it because rates are hiking up? Or is it because the Fed is hiking the rates up too little too late?
The Fed also has another trick they can use. Remember the 2008 crash? During that time, the Fed bought about $9 trillion worth of mortgage-backed securities (MBS). Why did they do that? Because they needed to pump a bunch of dollars into the economy to get it going. Now we need the opposite. Pumping dollars into the market would only make inflation worse, kind of like what those stimulus checks did. So now, the Fed is selling these mortgage-backed securities. This reduces the amount of money in the market.
In short, everything the Fed is doing is to try and hurt the economy for the long-term good. Unfortunately, it’s the only way out that we know of. Businesses won’t reduce their prices if everybody has the money to shell out, even if it means using up your entire paycheck to feed yourself for the month. By inducing a recession, prices will go down by necessity.
What you should do during an inflation?
In other words, what can we do as investors to minimize the effects of inflation in our own portfolio. By knowing what hedges against inflation, we can do better in acquiring assets during times like these. Here are what you should be doing and why. Keep in mind that this is not financial advice and should not be misconstrued as such. It is purely for educational purposes, and you should always consult with a professional financial advisor for your financial moves.
- Get a raise or change to a higher-paying job. Easier said than done, but most definitely possible in the current labor market. This is the best thing you can do to fight the effects of inflation in your own life.
- If you have a mortgage with a low fixed interest rate, keep it. You’ve borrowed money at a rate lower than the current environment, so you don’t want to pay it off. Instead, you could be using any extra money you might have on things that’ll give you a better return.
- If you have student debt with a low fixed rate, for the same reason, don’t pay it all off at once. The dollar is losing value, and the later you pay off the debt, the lower the value of the dollars you’re paying off that debt with.
- Treasury Inflation Protected Securities – as the name implies, these are treasury bonds designed to protect against the negative effects inflation.
- I Bonds – these haven’t been relevant for the last few decades, but they’ve recently seen a resurgence in activity. Any I Bonds purchased before 10/28/22 will get a 9.62% annualized interest rate, guaranteed for 6 months. For the following 6 months after that, it’ll fall to 6.48%. You get paid when it matures, or you cash it in, and you must hold it at a minimum for a year. You can buy a max of $10k worth of I Bonds a year.
What should you not do during an inflation?
Whatever you do, don’t convert to cash if you can. It’s a losing proposition, as inflation eats away at the value of cash. Instead, look for other ways to supplement your income, pick up a weekend job or try out some passive income ideas.
What causes inflation?
Inflation is generally caused by a combination of factors, and its exact causes can vary depending on the specific economic circumstances of a country or region. Here are some common factors that can contribute to inflation:
- Demand-Pull Inflation: This occurs when aggregate demand exceeds the available supply of goods and services. When consumers have more money to spend, they increase their demand for goods and services, leading to an upward pressure on prices.
- Cost-Push Inflation: This type of inflation is driven by an increase in production costs, such as wages, raw materials, or energy prices. When businesses face higher input costs, they may pass on these increased expenses to consumers in the form of higher prices.
- Monetary Factors: Inflation can also be influenced by monetary factors, particularly changes in the money supply and interest rates. When there is an excessive growth in the money supply without a corresponding increase in goods and services, it can lead to inflation. Similarly, if interest rates are too low, it can stimulate borrowing and spending, contributing to inflationary pressures.
- Government Policies: Government policies, such as fiscal policies and monetary policies, can impact inflation. Expansionary fiscal policies, such as increased government spending or tax cuts, can boost aggregate demand and potentially lead to inflation. Monetary policies, such as reducing interest rates or engaging in quantitative easing, can also influence inflation by affecting the money supply and borrowing costs.
- Exchange Rates: Changes in exchange rates can influence inflation, especially in countries that rely heavily on imports or exports. A depreciation in the domestic currency can increase the prices of imported goods, contributing to inflation. Conversely, a strong currency can reduce the prices of imported goods and potentially lower inflation.
- Expectations: Inflation expectations play a role in shaping actual inflation. If people anticipate higher future inflation, they may adjust their behavior, such as demanding higher wages or increasing prices, which can contribute to a self-fulfilling prophecy of inflation.
It’s important to note that these factors interact and can reinforce each other, leading to a complex interplay of economic forces that contribute to inflation. Central banks and policymakers aim to manage inflation within a target range to maintain price stability and support sustainable economic growth.