What’s going on with inflation?

July 26, 2021   |   Investing

Today, we have LifeGuide Partner and Chief Investment Officer, Zak Lutz, on hand to share some wisdom and insight into what we’re currently seeing with inflation. What should we make of the latest Consumer Price Index increase? Should we be concerned? How do we prepare for inflation?

Back in October 2019, I attended the Financial Planning Association’s annual conference in Minneapolis, MN. I remember hearing several economists talk about how they predict inflation would play out over the coming years.

Most said inflation was never going to come back.

One economist, though, said something that stuck with me: “Someone will figure out how to make it come back.”

The Labor Department recently announced last month’s Consumer Price Index (CPI) had increased by 5.4%  from a year ago, marking the highest twelve-month increase since August 2008.

And while the media has lost no time making fear-inducing headlines out of this, I want to suggest today that these fear-based narratives you may be reading or hearing about don’t tell the full story. Instead, if we pull back the covers and dig a bit deeper, I believe we’ll get a much clearer picture.

Comparing apples to apples

Comparing year-to-year data points do not always tell the full story. This is, in part, because of an economic phenomenon known as the base effect. Investopedia defines the base effect as “… the effect that choosing a different reference point for a comparison between two data points can have on the result of the comparison.”

The base effect creates distortions by comparing something happening now to an unusually low previous value.

In other words, it’s important to critically examine the two data points being compared. 

In the case of the latest CPI increase, prices appear to have changed so drastically because they are being compared to June 2020 when we were in the depths of the economic shut down due to the COVID-19 pandemic.

Yet when we compare today’s data to a more “normal” time—say June 2019—we see prices have increased by a more reasonable 3%/ year.

In other words, it’s important to critically examine the two data points being compared.

Another reason these inflation figures don’t tell the full story is because they don’t factor in the massive global supply chain disruptions experienced during the pandemic. (If you’ve tried to order something in the last year only to see a 12+ week lead time for delivery, you’ve experienced these supply chain issues.) 

Furthermore, inflation can be a bit of a self-fulfilling prophecy. If people believe prices are going to go up, they will rush to buy things while they’re less expensive. This in turn drives up demand which drives up prices and brings on inflation.

Let’s use the example of lumber. Not only were supply chain disruptions occurring as sawmills cut back production, but many consumers were unable to take vacations and instead opted to spend money on home improvement projects. Supply dwindled, demand spiked, and lumber prices shot through the roof.

The good news is that these supply chain disruptions are temporary and, in many cases, are already beginning to work themselves out. In fact, lumber futures have dropped by two-thirds since their high in May. More sawmills are coming back online, and demand is moderating.

The Fed has also reiterated their view that inflation is temporary, and many believe that inflation will settle down to 2% over the next two years.

Preparing for inflation

Let’s go back to the economist from that conference in Minneapolis. Have we indeed found out how to bring back inflation?

I don’t believe there is reason to be overly concerned right now.

However, I do believe the economist was right in that, someday, inflation will be back. So, while we shouldn’t be overly concerned now, it is still prudent to prepare.

Here are two ways we can effectively prepare for inflation:

1) Include inflation in your financial plan. 

• Inflation does have a significant effect over the long term. This is why every financial plan we create for our clients includes an inflation assumption higher than the current Fed target of 2%.

2) Be on both sides of the equation. 

• As consumers, we are stuck on the consumer side of the equation and will always be subject to higher prices on the things we buy. Yet we can prepare for inflation by being on the asset side of the equation as well. Investments like real estate, TIPS, commodities, small company stocks, value stocks, and emerging market stocks can hold up well in periods of inflation. Unlike other risks we hedge by investing outside of the equity markets, inflation is a unique risk because it can be hedged by investing in equity markets.

I hope this gives you a sense of peace knowing that, while headlines may seem scary, they don’t tell the full story about what we’re currently seeing regarding inflation.

As always, please reach out to your advisor if you have any questions or concerns. While we can’t give specific advice in this kind of format, your advisor is always here to help you determine what is right for you given your specific situation.

— Zak Lutz, CFP®, RLP®, CKA®   |   LifeGuide Partner & Chief Investment Officer