Inflation

Inflation is when the prices of commonly used goods and services increase in an economy, impacting the personal finances of consumers nationwide. Inflation occurs when demand exceeds supply, which triggers prices to increase in order to better balance purchasing power.

In the United States, inflation is most frequently measured by the Consumer Price Index (CPI), which is a weighted average of the essential goods and services prices.

The CPI is the most widely followed measure of inflation, but the U.S. Federal Reserve utilizes the Personal Consumption Expenditures (PCE) Price Index to inform its decisions. While the CPI measures the change in the prices of goods and services commonly used by urban households, the PCE index measures the change in the price of a broader set of goods and services consumed by all households and the non-profit institutions serving those households.

Inflation takes effect when the demand for goods and services can’t keep up with supply. The technical imbalance drives up prices as buyers bid up the price of the things they want and need. The larger the imbalance and perceived scarcity of things, the higher the rate of inflation.

The root cause of the imbalance is generally either a demand shock or a supply shock — however, they can occur simultaneously. A demand shock drives demand-pull inflation, while a supply shock drives cost-push inflation.

When inflation continues to rise, it can lead people to buy more before prices increase even more. Unfortunately, this accelerates the process, causing present-day prices to spike more quickly.

For the twelve-month period that ended on June 30, 2022, the CPI rose an alarming 9.1% — the largest increase reported in over 40 years. Excluding volatile food and energy products, the measure remains elevated at 5.9%.

A myriad of factors contributed to the price pressure, including COVID-induced supply chain disruptions, surging consumer demand and rising wage pressure across the economy. Geopolitical distress associated with the war in Ukraine also affected inflation rates.

Ultimately, the U.S. is experiencing a technical imbalance, where the demand for goods and services is surpassing the supply. As long as the gap persists, prices will continue to rise.

Since March 2022, the Federal Reserve has been attempting to eliminate the inflationary gap by applying interest rate hikes and other restrictive monetary policies. But so far, its efforts have yet to have a definitive impact.

A moderate and consistent level of inflation — arguably, about 2% — is generally considered a sign of economic health. But unexpected and rapid price increases can have a destabilizing effect on the economy and jeopardize the earnings of its people.

The problem is amplified for lower-income households and retirees living on a fixed income. Over time, inflationary pressure can diminish the purchasing power of these consumers, leaving them struggling to cover rising housing costs, food prices, energy bills and medical expenses.

When inflation flares up, it’s usually a headlining event that negatively impacts the average consumer. However, depending on the situation, it may not be all bad. Inflation has a differing effect depending on the market.

In the near term, unexpected inflation can have a detrimental effect on the employment market. Many companies experiencing rising costs are not able to immediately adjust the sales prices of their goods and services accordingly. Rather, they are forced to absorb the costs, which diminishes earnings.

This leads to cost-cutting measures, which often entail budgetary reductions and hiring freezes. In turn, it pushes unemployment rates higher and wages lower. Fortunately, the dynamic is usually short-lived. Over time, as firms are able to raise prices and bolster profit margins, the employment market re-strengthens.

As outlined above, unexpected inflation can have an adverse impact on companies over the near term. This translates to lower stock values, but the impact is not the same for all types of companies. Generally, smaller companies with minimal pricing power and financial ability are more exposed than larger companies with significant pricing power and deep liquidity reserves.

Similarly, growth-oriented and cyclical companies are more exposed than value-oriented and defensive companies.

But don’t put too much emphasis on the near term. With investing, a longer-term focus that reflects your time horizon should support the structure of your stock portfolio.

Regarding the real estate market, inflation can be good or bad, depending on your perspective. For prospective buyers, unexpected inflation is generally bad. It drives up both prices and interest rates, which makes acquisitions increasingly expensive and, eventually, unaffordable.

For property owners, inflation has less of an effect, largely due to the inflation-resistant nature of real estate property. Essentially, when you own real estate, you can benefit from two things — an ongoing stream of rental income and price appreciation. Both of these components rise with inflation. While some degree of lag exists, real estate is a great long-term hedge against inflation.

The precious metals market, which includes gold, silver and platinum, is another market that garners a lot of attention during high inflation. Historically, these assets have exhibited a high degree of resilience during prolonged periods of inflation. They have also provided a nice diversifying benefit to portfolios composed primarily of stocks and bonds.

However, precious metals have a major drawback — they do not yield any income. This causes them to significantly underperform when interest rates rise.

The most effective approach to protect against inflation is to maintain a flexible budget where you can temporarily adjust living expenses during tough times. Not everyone has the advantage of doing this, but for those who can, the benefits can be big. The ability to modify your lifestyle can help you avoid making untimely asset sales, preserve your savings and gain some emotional stability.

Another way to protect yourself is to invest in assets designed to hedge against inflation. Such assets have a high probability of generating increased levels of income in the face of rising prices.