Inflation Part 1: Five Things Retirement Savers Need to Know

Taylor Schulte: Welcome to the Stay Wealthy podcast! I’m your host Taylor Schulte and today I’m talking about inflation.

Specifically, I’m sharing 5 important things retirement savers need to know and set the record straight on a handful of inflation misconceptions.

And I’m not even going to waste any more of your time, except for a quick note letting you know that the show notes can be found by going to youstaywealthy.com/143.

So, as most listeners likely know, in January of this year, the U.S labor department reported that inflation was 7% in 2021, the highest level in 39 years.

While the news is not something to ignore, the headline doesn’t quite tell the whole story. But it sure has investors worried, I think I’ve had more questions about inflation in the last 30 days than in my entire career.

And look, inflation can be frightening. And it’s normal for fear to creep in. Fear is useful, It can help us avoid making costly mistakes or even life-threatening decisions.

But, as Professor Meir Statman recently put it,

“when fear is exaggerated, it can lead us wrong and steer us away from taking prudent risks. We can exaggerate our fears through cognitive shortcuts that turn into errors. Like extrapolating recent events and focusing excessively on what is readily available in memory. We are wise to pause, gather information and reflect on these errors before we act on our fears, potentially jeopardizing our investments and/or diminishing our well-being.”

To calm some nerves, especially for those in retirement or close to it, I’d like to first set the record straight on a few things and share 5 things I think you ought to know about the current inflation news.

First, for the most part, this was expected. In fact, I published an episode on inflation last October when the CPI numbers started to surface and said in that episode that Economists anticipate higher-than-average inflation to continue into 2022.

These inflation numbers followed a sharp increase in transportation as Americans began traveling and going back to work. Other price increases were a result of supply chain and labor shortage issues which, by most measures, appear to be improving.

In short, you didn’t need to be a finance and economic expert to know that prices in 2021 were going to be much higher than they were in 2020 when the world shut down due to a global pandemic. Inflation typically rises during periods of economic growth, so we shouldn’t be totally surprised by the recent inflation news. Again, it doesn’t mean there isn’t any cause for concern or that we shouldn’t spend time better understanding the economic landscape, but contrary to what many headlines are leading us to believe, this wasn’t a complete surprise.

Second, retirees are likely able to navigate the current spike in prices better than anyone else. In addition to having more flexibility when they travel and not commuting to work, many day-to-day expenses for retirees weren’t affected at all. For example, medical services saw an increase of 2.5%, and the cost of prescription drugs didn’t budge year over year. Heck, even dairy only saw an increase of 1.6%.

On the other hand, the price of gasoline jumped nearly 50% and we all know what the used car market looks like right now. Retirement income sources, like social security, are also adjusted for inflation. As noted in the episode I published last October, which I’ll link to in the show notes, CPI can be wildly misleading. The CPI index is up 7% year over year but that doesn’t mean that everything you buy and consume is up 7%.

Third, contrary to what you were taught or how you feel, inflation is actually a good thing. Again, inflation typically rises during periods of economic growth. Inflation also reduces the cost of borrowing because you’re paying the lender back with dollars that are theoretically worth less than the dollars loaned to you. It also typically leads to higher wages, often referred to as wage growth.

And finally, as we all know, and we’re experiencing right now in certain sectors, corporations pass on the higher cost of doing business down to consumers, which in turn maintains or even boosts their bottom line. And that’s precisely why, historically, the boring plain-vanilla stock market has been the best hedge against inflation.

In fact, when inflation is between 5% and 10%, the real return for stocks (remember, real return means adjusted for inflation), the real return for stocks when inflation is between 5% and 10%, was 4.8%.

However, time and time again, when investors are surveyed, they overwhelmingly state that commodities are the best hedge against inflation. Unless you have a crystal ball and can trade in and out of commodities at all the right times, it’s a long-term losing proposition to hold commodities to fight inflation. The Goldman Sachs commodity index trades today just about where it was 31 years ago. Commodities are a trading vehicle, not a long-term buy-and-hold investment.

Now, while inflation can be viewed as a positive, runaway inflation or hyperinflation is not.

But here’s the deal, hyperinflation doesn’t just happen overnight, it’s typically a slow process. And, technically, to be in a hyperinflationary environment, we would have to see a continuous 50% increase in the rate of inflation year over year, it’s not just a few upticks in inflation readings or higher-than-average CPI numbers for a short period of time. It can literally ruin an economy for decades.

Also, historically, hyperinflation tends to occur around major geopolitical events like losing a war, social turmoil, or large foreign-denominated debts that require money printing not supported by economic growth.

Personally, I think the odds are low for hyperinflation at the moment, especially since our government has proven time and time again that they will take drastic action to control it, even if it comes with substantial costs in the short term like a recession or a spike in interest rates or unemployment.

However, you wouldn’t be completely alone if you disagreed and you thought hyperinflation was around the corner. There are some interesting and somewhat compelling arguments.

For what it’s worth, the U.S. last saw hyperinflation during the revolutionary war in 1779 and the civil war in 1864 when the inflation rate peaked at 47% and 40% respectively.

While we haven’t seen the textbook definition of hyperinflation in 150 years, we have seen some high inflationary time periods in recent history. Most people bring up the 1970s sharing when concerns about inflation and what might lie ahead for this country. Because from 1970 to 1980, when inflation bounced between 6% and 15%, the S&p 500 had an average annual real return of less than 1% per year. Your bank account grew pretty significantly but adjusted for inflation, you barely broke even.

Now, if we stretch out that time period a little more from 1969 to 1982, things get uglier…you actually had a negative real return. Your investment in u.s. stocks returned about 7% per year but adjusted for inflation, your return dropped to a negative -0.23% per year.

It’s important to note that there are a number of key differences between what happened in the 1970s and what we’re dealing with today. Even more, many experts still can’t quite pinpoint exactly what happened in the 1970s. You can read dozens of books and theories, some of which I’ll link to in the show notes, but most still leave you with more questions than answers.

That being said, most experts agree that the current economic environment, and the inflationary spike we saw in 2021 as it relates to supply and demand, is very different than what we saw in the 70s. Anything can happen, but currently, the odds appear to be low for a repeat of that difficult time period.

So, the 70s were tough, but you might remember that we also saw an inflation spike in the 1990s. Inflation crossed just over 6% in the fall of 1990 and the economy was going through a pretty nasty recession. Thankfully, it was short-lived and what followed was one of the biggest booms for the U.S. economy and the stock market for the next 10 years.

And this leads to my 5th and final point which is that inflation is volatile and also very hard to predict. The San Francisco fed actually produced a research report that looked at different inflation models to evaluate their predictive power and the results were not that great. The average forecasting error was at least 1.5%, which might not sound like much, but when the fed has a published target inflation rate of 2%, that 1.5% is a pretty wide margin of error.

The conclusion to the analysis from the San Francisco Fed stated,

“...financial markets can provide little additional useful forward-looking information about inflation….These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information.”

That was a lot so let me summarize my five points:

1. The recent spike in inflation was mostly expected
2. Retirees are likely able to navigate the current spike in prices better than anyone else
3. Inflation is a good thing
4. Hyperinflation is not a good thing but doesn’t happen overnight
5. Inflation is volatile and very hard to predict

Even if you don’t agree 100% with my comments today, the question still becomes, what do you do? What do you do with the information we have available to us and the conclusions we, as individual investors, have drawn from it?

Sometimes, as the late John Bogle said,

“don’t do something, just stand there.”

In most areas of our life, we have to take action to see results. If we want to lose weight, we have to eat healthier and exercise more. If we want to improve our golf game (or pickleball game which my wife and I just picked up), we have to practice. But investing is one of those unique things that require patience and, more times than not, the answer is to do nothing.

Doing nothing, however, is contingent upon you having a solid investment retirement plan in place. If your investments are heavily weighted towards U.S. stocks or growth stocks, it likely makes sense to take action. If you own high-cost alternative funds or commodities, it likely makes sense to take action. If you don’t have a retirement plan or you haven’t updated it lately, it likely makes sense to take action.

And if you’re not sure exactly what action to take with your investments, you might revisit my retirement investing series as well as episode 131 from last October where I first talked about inflation and some of the different actions you can take, including information on Treasury Inflation Protected Securities (TIPS).

I know some of you have been asking about ibonds, which are also something to consider. I shared what they are and the pros and cons last year as well and will link to that episode in today’s show notes.

Lastly, if you’re a finance nerd like me and like playing around with historical returns, especially historical returns adjusted for inflation, I’ll also be linking to a free tool in the show notes that allows you to choose a desired time period (i.e. 1970 to 1980) and starting investment amount (i.e. $100,000) and then it shows you how your investment in U.S. stocks did adjust for inflation. It also provides some other information on that time period in an easy-to-digest format.

So, to grab that free tool, and access the other links and resources mentioned today, head over to youstaywealthy.com/143.

Thank you as always for listening and I'll see you back here next week.

Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.