If you feel like things are more expensive, you are right. Despite a slightly weaker than expected inflation report in April, this year, prices have accelerated faster than Fed officials anticipated just a few months ago. Last week we learned that headline inflation increased to a 14-month high of 2.5 percent from a year ago in April, due in large part to rising gas prices. Excluding food and energy the core rate increased by 2.1 percent.
Inflation occurs when the prices of goods and services rise and as a result, every dollar you spend in the economy purchases less. But it’s been a long time since the double-digit rates of 1979-1980 and in fact, the annual rate of inflation from 1917 through 2017 averaged just over 3 percent annually. That might not sound like much, but consider this: today you need $7,283.31 in cash to buy what $1,000 could buy 50 years ago.
Over the past decade, deflation (a drop in the price of goods and services) -- not inflation -- had been the concern of Federal Reserve policy makers. When deflation is persistent, it can put into a motion a scary, downward spiral that can cause an economy to stand still. To prevent it, the Fed kept interest low at zero and purchased bonds, the combination of which was intended to spur demand and prop up asset prices.
Inflation hawks like Paul Ryan attacked the central bank’s policy and even tried to “school” then-Fed Chair Ben Bernanke in 2011, warning that “the inflation dynamic can be quick to materialize and painful to eradicate once it takes hold.” But as it turns out, Bernanke and Yellen were right: the tepid recovery, combined with an aging population and technological advances, kept a lid on overall prices.
That fact may bring cold comfort to most Americans today, as prices have begun a stead climb higher. According to economist Joel Naroff, “even though inflation did not jump in April, neither did wages. When you adjust the rise in hourly earnings by the increase in consumer prices, you find that household spending power went nowhere. Worse, over the year, consumer costs were up by 2.4% and hourly earnings by 2.6%, so real earnings rose a pathetic 0.2%.” In other words, some households are just barely breaking even. Adding to the concern is that cost of servicing debt is also rising, as the Fed continues to increase short-term interest rates and the market is pushing up long-term rates.
So how should you adapt to the new economic order? Start by locking in adjustable loans into fixed rate ones. 30-year mortgage rates have increased to four-year highs and they are likely to keep moving higher. If you are waiting for that 3.5 percent loan, forget it and manage your debt load in the newer, higher rate environment.
As far as investments, your goal is to grow your portfolio at a quicker pace than the rate of inflation, while keeping focused on the total risk level you are willing to assume. While no single asset acts as a perfect inflation hedge, consider the following:
Commodities: When inflation rises, the price of commodities like gold, energy, food and raw materials also increases. However, this is a volatile asset class that can stagnate or worse, lose money, over long stretches of time. Therefore, investors would be wise to limit commodity exposure to 3 - 6 percent of the total portfolio value.
Real estate investment trusts (“REITs”): The ultimate “real asset”, REITs tend to perform well during inflationary periods, due to rising property values and rents.
Stocks: Many investors don’t think about stocks as an asset class to combat inflation, but long-term data show that stocks, especially dividend-producing stocks, tend to perform well in inflationary periods. That said, during short-term inflationary spikes, the stocks might drop before reverting to the longer-term trend.
Treasury Inflation Protected Securities (“TIPS”): Rising prices can diminish a bond’s fixed-income return. But the US government directly offers investors inflation-indexed bonds, or TIPS, which proved a fixed interest rate above the rate of inflation, as measured by the CPI.
International Bonds: Inflation can shred the value of the U.S. dollar so consider a small allocation to international bonds, which are denominated in foreign currencies.