Inflation is a silent, but persistent force that impacts all of us. It’s not until we look back several years later though that we realize how our dollars have gotten devalued over time.
When it comes to managing your long-term net worth growth, inflation becomes an important factor that you need to consider in your wealth management strategy. If your year-over-year growth falls behind the inflation rate, the value of your nest egg is effectively diminishing over time.
Let’s review some fundamentals on inflation so that we can learn how to combat it in the long run.
What Causes Inflation?
Inflation refers to increases in the cost of goods and services. Price increases can be caused by several underlying factors:
Increase in demand
When demand increases for a good or service with limited supply, their corresponding prices are likely to increase as well. We’ve seen many fluctuations in demand for goods this year based on changes in consumer behavior.
For example, when my husband and I decided to purchase an inflatable hot tub during quarantine, prices had more than doubled due to higher household demand. Another weird spending habit you see in times of crisis? Lipstick.
We're constantly chasing new trends and evolving our needs thanks to technology and lifestyle changes. As long as there is demand for a product and a limited or finite supply, inflation will most likely be at play.
Increase in production costs
Prices also increase when the cost of raw materials increases and this cost is passed onto consumers.
Last year when we were looking for new flooring for our bedroom, the price of wood and vinyl sourced from China were notably higher due to the impending trade war. With more complex and global supply chains, prices can be impacted by many different factors in the production and distribution process.
Built-in inflation is a phenomenon that occurs when price increases in the past drive expectations about higher prices in the future. This becomes somewhat of a self-fulfilling prophecy as employees demand higher wages in anticipation of future inflation. Businesses subsequently then bake in price and cost increases into their products and pass them onto the consumer.
How is Inflation Measured?
The most popular measure of inflation is the Consumer Price Index (CPI). The Consumer Price Index takes a weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care, and tracks the change in these prices. These changes effectively reflect how our cost of living adjusts over time.
Below is a chart that shows inflation rates since 1960 based on the Consumer Price Index.
Inflation spiked dramatically in the 1970’s based on the 1973 oil crisis that hiked up the price of oil by nearly 300% per barrel. Since 2012 though, inflation has stayed relatively stable, tracking at or below the 2% mark annually. Thanks to technology, globalization, and information sharing, we don't see the same type of price shocks for goods and services or raw materials that spurred higher inflation rates in former decades.
The Federal Reserve is responsible for maintaining a stable economy and managing inflation levels through monetary policy. Low and stable inflation rates are thought to minimize unemployment rates and create better price stability.
Interest rates are also intertwined with inflation rates. When inflation runs too high, interest rates are typically raised to slow down the economy and discourage borrowing. Consequently, interest rates are lowered when inflation rates run too low to encourage more borrowing and stimulate the economy. This is one of the reasons we've see relatively low interest rates over the past decade.
The Fed aims for an annual target rate of inflation of 2%. Last month, however, the Fed announced a major policy shift that would allow inflation to run moderately higher than 2% to compensate for several years of lagging growth.
With little wiggle room to lower the rock bottom interest rates we are seeing today, the Fed has less ammunition to stimulate the economy if we hit a rough patch again in the coming years. Therefore, letting the economy run hotter than normal allows areas like unemployment improve without putting the US at risk of dangerously low or even negative interest rates.