5 Things You Should Know about Inflation

5 Things You Should Know about Inflation

It’s a big investment no-no to take the current investment environment as the norm as opposed to viewing it within the spectrum of historical returns. When prices zoomed up without rhyme or reason during the tech bubble, people assumed it would just continue forever. There are people who bought property all over the U.S. in 2006 and 2007 (sometimes sight unseen!) because they couldn’t fathom real estate ever decreasing in value.

That brings us to the current inflation environment, where the Consumer Price Index (CPI) currently resides at 2.1%. While you may hear a lot of chatter about overpriced stocks or a possible bond bubble, inflation might currently be the most important factor to consider when constructing your portfolio.

Here are some things to remember:

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Inflation eats away at your investment returns

We all know that inflation is bad, but why? The easy answer – it eats away at the rate of return on your investments. If you make 3% on your money during a period of 3% inflation, the “real” rate of return on your investment is zero. If my wife keeps baking cookies and I keep eating them all (not an entirely unrealistic situation), where does that leave her? Cookie-less!

Inflation has been low for many years

Basic economics tells us that the economy moves in cycles. While we don’t know the length of time these cycles will last, we do know that what goes up must come down and vice versa. So, while economists continue to predict low inflation for the next 10 years, you can take solace in this fact – economists are almost always wrong. The biggest problem right now is that even with low inflation, wages are stagnant. If we don’t start to get wage increases to fight 2% or higher inflation, it’s going to really hurt.

The “Core CPI” doesn’t take food or energy into account

It’s the policy of the Fed to focus on “Core CPI”, which excludes food and energy, the argument being that the price of food and energy is too volatile to be meaningful on an ongoing basis. Well, if you live here in Rhode Island or you’re protesting in the Middle East, you’re feeling the effect of rising prices at the gas pump or the increased cost of food. The extra money you’re spending on those items is going to decrease your bottom line.

The Federal Reserve is trying to increase inflation

The second round of Quantitative Easing (QE2) by the Federal Reserve Board is meant to continue their policy of stimulating the economy by pumping more money into it. This fights deflationary pressure but it can be argued that this policy is responsible for the rise in price for food and gas that we’ve seen in the last quarter.

There are investments specifically tailored to increase with inflation

As you would expect, there are investments engineered to rise with inflation. As discussed here before, TIPS offer an inflation premium on top of government bonds. Several mutual fund companies offer a “Real Return” option, which combine TIPS of different maturities and other bond derivative strategies.

Dan Forbes is a regular contributor on business financial issues. His office is in Providence, RI. He leads the firm Forbes Financial Planning and can be reached at [email protected]