Planning for Lasting Inflation

If you’ve been to a grocery store lately, the announcement from the Federal Reserve last week should not have been surprising: inflation seems to be sticky. While some progress has been made in reducing the inflation rate, prices remain elevated and are getting higher on many necessary goods and services. Though the inflation rate may not be as high as it was a year ago, remember that the inflation rate is the measure of price increases. For a 60-year-old retiree, a 4% inflation rate means prices will have doubled by age 78 (18 years).

Sticky inflation leaves the Federal Reserve in a position of “wait and see.” For us consumers, this likely translates to higher interest rates for a longer period. Furthermore, several large companies reported earnings last week that consumers were beginning “to crack,” essentially saying that while the economy has been buoyed by strong spending over the past few quarters, they’re starting to see a slowdown. People simply can’t afford higher prices and to keep spending at the rate they have been.

You may or may not relate to this feeling. Afterall, we experience inflation in our own way. If you purchased a home in 2015 and refinanced just prior to or during COVID, your monthly outlay for housing is very different than someone who is renting. The graduating class of 1995 has a very different student loan burden than the class of 2025. The inflation of different lifestyles and life stages has never been more apparent than today.

Wherever you may fall on the spectrum, it is increasingly important to plan for a lengthy period of high inflation. First, I think we need to better understand where inflation is coming from and why, then discuss how we can deal with it now and into the future.

Imagine you’re on an island. On this island there are ten apples and ten dollars. A balanced economy suggests the price of each apple should be one dollar. This supply and demand balance is essential for keeping the economy in check. However, it’s easily disrupted when variables begin to change.

If two apples spoil, the price on the other eight suddenly increases to $1.25. Akin to the supply shocks during COVID, the difficulty in producing the necessary supply to meet demand meant prices would increase. Furthermore, if there are ten hungry mouths on the island and only eight apples, those eight people might spend even more to secure one of the apples. Demand has increased beyond supply, meaning those $1.25 apples might sell for $1.40 or more.

As another example, let’s say we have a secret money printer stashed somewhere on the island. Our unfair advantage gives us the ability to buy as many apples as we want. Any time we need another dollar, we simply turn the printer on. But as time passes, more money is introduced to our little island economy. Suddenly that dollar doesn’t buy as much as it once did. If we have ten apples and $14 dollars (as we printed an extra $4), the price per apple is now at $1.40. During COVID, billions of dollars went toward ensuring the liquidity of the market and providing a backstop for businesses and individuals unequipped to handle the sudden closure of the worldwide economy. About 40% more “money” as measured by the M2 money supply, was printed into the American economy. The result is higher prices.

Considering these examples, sticky inflation should come as no surprise. The hope was supply imbalances caused by COVID would eventually disappear, effectively bringing supply back up to meet demand. Through economic growth, we could then absorb the additional money introduced during the pandemic (akin to growing more apples.) Though this has occurred in some respects, the overall outcome is apparent.

To provide the pandemic assistance, the government borrowed money at an historic rate. Just like automobile, credit card, or interest rates in general, now as the bill comes due the U.S. finds itself in a difficult place. Looking at the 2024 Federal Budget, roughly 13% or $870bn of spending goes solely to the interest on government debt. The government is operating at a 24% deficit, so to meet its spending obligations it must borrow roughly $1.58 trillion.

Billions and trillions are hard to grasp, so think about it like this: If I had a client tell me they were spending $8,700 per year on credit card interest, that would be a problem. If they then put another $15,820 per year on that same credit card, I wouldn’t know how to help them. If that same family makes $50,000 per year but spends $65,000 (government income is $5 trillion and expenditures are $6.5 trillion) they’re going to find it difficult to increase their income enough to offset their expenses. The way out is spending less and increasing the income.

Our goal as investment advisors is to protect and grow the purchasing power of your money. If the path forward is higher prices, your income must grow alongside those expenses. Fixed income is a slow path to unaffordability.

We believe one of the few ways to protect purchasing power over time is with dividends. As an example, consider the total dividend of companies in the S&P 500 in 2022 of $67.57. That number grew by 5% to $70.91 in 2023. If your income grows by 5% and inflation is rising at 4%, you have a net 1% increase in your real purchasing power. We believe in the long run there’s only one rational long-term investment goal: growing income. Zoom out and the trend remains consistent. The growth of the S&P 500’s dividend has soared since 1980 at nearly twice the CPI inflation rate.

Outsized inflation could be an uncomfortable reality for the coming months and years. There’s little we can do to affect the inflation rate, so our best course of action is preparation and planning. Consider how continued inflation might affect your financial plan and ask your advisor what they’re doing to ensure your purchasing power remains unaffected over your lifetime.