The Rising Tide of Prices and What it Means For You

This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth

Inflation. We can’t read the news or turn on the TV without hearing about the rising inflation rate. We constantly hear headlines about rates reaching first thirty, then forty-year highs. Even when we put our devices down, inflation is hard to ignore. Whether it’s prices at the pump or higher grocery bills, we see inflation all around us, and many clients have been asking what this means for them. In response, we thought we’d share a bit about the history of inflation rates in the U.S., how today’s rates compare, and some common ripple effects of inflation that impact you.

The prices we pay for goods and services change over time. More often than not, these changes are in the upward direction. Inflation is a measure of the rate at which prices rise, and this rate speeds up when certain drivers are present in the economy. One driver of rising inflation is strong consumer demand for a product or service. When there’s a surge in demand for a wide breadth of goods across an economy, their prices tend to increase. Another driver is rising production costs including raw materials and wages. If it costs more to create a good or service, the prices consumers pay tend to increase, too. The surge in inflation we’re experiencing today is a combination of strong demand and rising costs due to factory shutdowns, supply chain bottlenecks, and a labor shortage putting upward pressure on wages. Overall, inflation ended the2021 year up 7% over the same period last year.

While today’s rate seems high compared to the average in recent decades, it’s helpful to consider that it is nowhere near historical highs. We can look back at the late 1970s and early 1980s for some perspective. That period is famous for rampant inflation, which reached almost 14% at its peak. Yes, the economy did suffer from a recession during that time, but there were other contributing factors beyond inflation that we are not seeing in today’s economy such as high interest and unemployment rates.

Consumer Purchasing Power
Rising prices mean that the products and services you buy are more expensive. That said, inflation doesn’t necessarily mean your ability to buy products (purchasing power) is declining. Your income may be increasing enough to keep your purchasing power the same or even increase it! On the other hand, if your income isn’t keeping up with inflation, it may be wise to reassess your spending habits since rising inflation may reduce your ability to purchase at the same level.

Investments
Higher inflation means that the real return, which adjusts for the impact of inflation, will be lower than it looks. Additionally, inflation impacts stocks and bonds differently, and its impact varies further within different asset classes in the stock and bond categories.

• Stocks – Looking back at what has happened to stocks in past inflationary environments can provide useful insight. Overall, stocks have historically been more volatile when inflation is high. Growth stocks are a great example. Because inflation has driven down the perceived value of future cash flows, growth stocks like technology companies have struggled at the start of 2022. Value stocks, which include companies in the energy and industrial sectors, tend to perform better in high inflationary environments as investors put more focus on the strong income and cash flows that are potentially driven up by inflation. Still, certain segments of the market are better positioned to withstand rising inflation and maintain margins and earnings levels, particularly those companies and sectors that can pass on higher costs to consumers.
• Bonds – When you buy a bond, the value is based on the future interest payments the bond will provide. Higher inflation means that these future interest payments can buy less than they did at lower prices, which make bonds less desirable and typically causes prices to decline. In periods of high inflation, the Fed often increases interest rates. We’ll discuss why in a bit, but it’s important to note that rising interest rates further reduce existing bond prices because bond owners are locked into prior, lower interest rates while current investors have the opportunity to earn higher interest for virtually the same bonds. The upside here is that as interest rates rise, you have the opportunity to buy bonds that earn more interest.

Real Estate & Loans
Current homeowners generally see the value of their homes appreciate as inflation rates begin to rise; however, the longer-term impacts of inflation on housing prices are less predictable. In response to rising inflation, the Fed often raises interest rates. As interest rates increase, borrowers start to get priced out of higher loans. This limitation on access to capital puts a cap on real estate price appreciation, particularly for lower-cost homes.

Homeowners that have already locked in a fixed-rate mortgage, or even refinanced at the low rates available in recent years, will of course have the advantage of continuing to make fixed interest payments regardless of rising interest rates. Effectively, if income rises with inflation but the home payment remains stable, the house payments become a smaller percentage of income. On the other hand, prospective homebuyers and renters may not reap the same benefits. With interest rates expected to increase, those in the market for a home can expect higher interest rate options. Similarly, those leasing homes will see rent increases, as well.

Throughout most of the pandemic, the Fed has kept interest rates close to zero to help the economy. However, the Fed plans to raise interest rates several times this year to mitigate spiking inflation with the backdrop of low unemployment. This begs the question, how do rate hikes achieve this goal? In short, higher interest rates make it more expensive for consumers and businesses to borrow. Higher borrowing costs typically drive down the demand for credit and restrict economic growth, which tends to result in falling prices and inflation rates.

For those of us who have lived through it before, an inflationary environment can raise concerns. The good news is that the investment and financial advice we provide is comprehensive and designed to prepare clients for the long term regardless of where we are in market and economic cycles. If you have specific questions about how you’re positioned to weather an inflationary period, the Aldrich Wealth team is here to help you navigate your unique circumstances.