Inflation: How to protect (and not predict) your future

Inflation. It’s not just a word that you learned in economics class - it’s a real market force that has a very real impact on your everyday life. Most importantly, inflation will affect your ability to afford your future. Have you ever heard your grandpa say ‘back in the day when movies were a nickel and you could get a cheeseburger for ten cents!’? Well - that’s because of inflation! Inflation means that goods get more expensive over time. The way we think about it is that the buying power of a dollar today is worth more than it is tomorrow. If you hadn’t considered this before, or if you assumed that things will just “balance out” in the future, then this article is for you!

Why do we care about inflation?

1. Inflation impacts our future expenses.

2. Inflation dictates how much more money we have to make year over year to avoid changes or restrictions to our lifestyle. 

3. Inflation impacts which investments do well and which do not.  

In this blog, I’ll give you a background on what inflation really means, the factors that drive inflation up or down, and the implications it can have on your life and in your investments. My hope is by the end of this blog, you’ll understand how to practically apply strategies that improve your future purchasing power, no matter where inflation goes. 

How do we measure this concept? 

There are a number of ways to measure inflation, but the most common is called the Consumer Price Index. The US Consumer Price Index measures the costs of a “basket of goods” for an urban consumer. What’s in the basket? All of the essentials of daily living, as well as expenses related to your lifestyle. The basket includes housing, transportation, medical care, education, food and drinks, apparel, recreation and other goods and services. 

Another important way to measure inflation is the US Consumer Price Index excluding Food and Energy. This model is more stable, because the costs of food and energy are volatile - they go up and down with greater frequency than other goods. Some examples of why this is the case:

1. Food grows from the earth or is fed from the earth (or at least that’s our preferred food!). Natural disasters such as tornadoes, floods, and droughts can wipe out important crops (on which livestock might depend) for large periods of time, limiting supply and sending prices sky high! Let’s take soybeans as an example - over a period of 4 months in 2016, soybeans prices rose by 36%. Two factors influenced this price increase: 1) extreme weather events in Brazil and Argentina, two of the world’s leading producers, and 2) increased demand for soybean products in mainland China. By contrast, tariffs on imports of US soybeans into China can drive costs down due to lower demand.  Just two years later, over a period of 5 months in 2018, soybean prices dropped by 23%. 

2. Energy includes oil & gas, which infamously experience huge swings in prices. In 2014, crude oil reached highs over $100/barrel due to rising demand in China. But as suppliers recalibrated their strategies, this growth came to a quick-rolling halt - dropping 68% over a period of 18 months. 

The global supply and demand forces that drive food and energy prices can be extremely volatile, and are deeply influenced by both the natural environment and political affairs. 

Below we show a chart of US CPI vs. US CPI ex: Food & Energy. While on the whole, their average is similar, US CPI ex: Food & Energy provides a more stable look at prices in the US. 

Since 2000, the level of US CPI excluding Food & Energy (the orange line) has stayed between 1-3%. There are a lot of economic theories as to why this is the case, but our view is that inflation stayed reasonable despite the world’s tremendous growth over the past twenty years because of globalization and technological development. Globalization has forced companies around the world to compete with each other for the global demand. Higher competition means that prices can’t increase too much, because a competitor would swoop in to take the demand (think Amazon). And this works because continued technological development has enabled companies to produce goods and services more efficiently (therefore at cheaper price points) than in times past. 

If inflation is so low, why are we talking about it? 

1-3% inflation doesn’t mean that everything increases by 1-3%. That’s just the average. The price of a new car, for example, has only increased 0.1% since last year. Used cars have actually dropped in price by 2%. The cost of furniture and bedding has increased by 1%. Still, some of our biggest costs are above this threshold. Education and Housing - up 3%; Medical Care - up 4.5%! 

If we don’t consider these rising costs as part of our financial equation, undersaving for goals is a real risk.  Let’s say you want to send your child to a private university in 15 years, and currently that university costs $35,000 per year. Over four years, you’ll need $140,000. Now let’s consider an inflation rate of 3%. In 15 years, that same university will cost $54,528 per year or almost $220,000 over a four year period. Without investing, that’s the difference of saving $777 per month vs. $1,211 per month (it’s no surprise that student debt is such a big issue). 

If you’re planning to work for yourself over the long run, or take an early retirement (before age 65), health care inflation is absolutely critical to consider. Since 2000, costs of medical care in the US have generally increased by 2-5% each year. These costs are comprised of health insurance premiums, hospital visits, prescription drug medication and other medical services. A Silver health insurance plan in Los Angeles, California is expected to cost a family of four $1,159 per month (or $13,912 per year) and in New York, New York is expected to cost the same family $1,772 per month (or $21,266 per year). Twenty years later, assuming inflation remained at 4.5% (where it is today), the Californians would pay $2,795 per month or $33,540 per year and the New Yorkers would pay $4,273 per month or $51,282 per year. To make things more complicated, both the need for and cost of healthcare typically increases over your lifetime, so you’ll want to save for inflation + increased out of pocket expenses. 

The last big expense is housing. The price of rent is going up on average 1.7% in the US, but depending on the size of your home and where you live, this number may be higher or lower. Below is a chart from Apartment Guide, which shows the average rent change of a two bedroom by state. Wyoming is -12% year over year, while neighboring Montana is up 22%. West Virginia rent prices increased 77%! 

So what can you do about it? 

A big part of financial life planning is understanding that certain components of our life can become increasingly more expensive than others. By deeply understanding your current finances and projecting realistic future expenses, you can better predict what you need to save today in order to prepare for tomorrow. 

If you discover you should be saving more on a monthly basis, you can do this in one of two ways: 

1. You can spend less, or 

2. You can make more 

Many industries and companies will incorporate a cost of living adjustment (COLA) into their compensation program, thereby automatically increasing employees wages each year. The COLA isn’t always equal to inflation, but is typically driven by a consistent formula that starts with one of the inflation measures. Similar to inflation, we’ve seen automatic cost of living adjustments range from 1-3%.  In 2020, Social Security COLA is 1.6%, whereas in 2019 it was 2.8%. 

If you are actively employed, we encourage each and every one of you to ask for a raise. Not just this year, but every year. Even if you receive a COLA. Now, we wouldn’t recommend using inflation as your primary reason for requesting the raise; rather, you should be armed with a competitive analysis of your role in the marketplace, a list of your accomplishments and how you beat expectations, and a compilation of all of the compliments you received for your job well done. However, the underlying story is that your costs are going up, so you might as well at least get paid enough to cover those increases.  If you want to know the average increases other full-time workers have received across the US -- over the past 10 years, wage growth has ranged from 2-6% on a year over year basis. 

Based on our experience in working with tech and finance professionals, it’s likely you’re receiving bigger increases in your salary, bonus and stock compensation. All the while, your employer is covering your health care costs. For professionals in this situation, we recommend staying focused on living within your means. Even if you’re at the average wage increase of 4%, by removing the need to pay for health care insurance premiums from the equation, your average inflation should be lower than others. We see this as a golden opportunity to build wealth and construct advantageous investment goals.

Prioritizing increased income and increased saving on a monthly basis is a proactive approach to combat any risks around future inflation. It’s important to understand that while the average inflation has been 1-3% over the past 20 years, this has not always been the case (and may not be the case in the future). Below is a chart of the Consumer Price Index dating back to 1948, highlighting 1980 when inflation rose to almost 15%. The gray bars represent recessions, typically occurring during peak inflation, sharp declines in inflation, or negative inflation (deflation). When it comes to inflation, slow and steady wins the race. This is why the Federal Reserve’s responsibilities are to “promote maximum employment, stable prices (that’s the inflation piece!), and moderate long-term interest rates in the U.S. economy”.

Why might inflation change? 

Economic theories teach us that a sharp decrease in supply or a high increase in demand will drive up prices or cause an increase in inflation. But a look into history might highlight some key attributes that impact the direction of prices.  I’m only summarizing -- credit for the research and “Tolstoy Model of Inflation” goes to Dr. Yardeni in his book Predicting the Markets in the Chapter Predicting Inflation. 

The most extreme cases of supply and demand shocks come during war times. In times of war, global markets are fragmented and trade is halted. Commodity prices sky rocket, because raw materials are needed for war efforts. Because soldiers are fighting overseas, there is a lack of supply of domestic workers. Wages rise for those left stateside. War = high inflation. 

On the contrary, peacetimes mean that everyone works together. Peacetime is what we’ve seen over the past 30 years as countries and companies expand their global reach. This, in conjunction with technological development, drives innovative change and drives down prices. 

What we can gather from these extremes is that if the world stops working together, prices will go up. But what happens if prices go down? Isn’t this a good thing? (This is called deflation). 

Well - not exactly. If prices go down because of competition, and the costs to produce also drop, then that’s fine for the company and great for the consumer. But if prices go down so much that companies can no longer remain profitable (or worse - they go out of business), then layoffs will happen and the consumer is no longer safe. The most salient and extreme example of deflation in the US is the Great Depression. 

What investments work in each environment? 

Here’s an important lesson: no matter the level of inflation, investing is how you generate real returns. We’re not talking real like the opposite of fake, real returns means: the return you receive from your investment minus inflation. 

Russell Investments did an analysis on the costs of staying in cash over the past few decades. The chart below shows the returns of investing in a 12 month certificate of deposit each year since 1984. Back in 1984, 12 month CDs were generating nearly 10% interest or a real return (after inflation) of over 5%. However since 2010, investing in CDs would have generated a negative real return. 

Source: CD Rates: Bankrate from 1984-2009; Federal Reserve Economic Data (FRED) 2010-2018. Inflation: FactSet Financial Data.

We aren’t saying “don’t keep cash”. You should always have at least 3-6 months of cash stored in an emergency fund (we suggest a high yield savings account), but beyond that, keeping your money in cash is a sure way to deplete your net worth over the long haul.  

Since 1981, bonds have been a great way to grow your money. As interest rates continue to fall, bond prices will continue to grow. With low or falling inflation, receiving a fixed rate of return provides you with real growth, because it exceeds inflation. If inflation starts to rise, investing in bonds can have the same impact as the CDs shown above.  However, if inflation falls, bonds can protect investors by providing a stable stream of fixed income. 

On the contrary, if inflation is on the rise, investing in cash and investing in bonds are both sure ways to deplete your assets. Depending on the rate of inflation increases, stocks may be dangerous if companies are coming under pressure to keep wages high. This is when alternative asset classes come into play: specifically real estate and commodities. 

• Real estate: you pay a fixed amount for your mortgage on an asset that grows. The caveat is that you need rising income to support your rising property tax expenses. If we flash back to the 1970s, California real estate prices were increasing by 150% year over year (known as hyperinflation), which ultimately led to Prop 13, officially named the People's Initiative to Limit Property Taxation. Even today, property taxes in California can only increase up to 2% per year, absent any material changes made to the home.  

• Commodities: a storage of value at a time that the dollar is losing its value. People flock to gold as a ‘safe haven’ and more recently, bitcoin has been considered as a storage of value. Similarly, energy prices often spike when inflation is high. Mana was quoted in CNN on how investing in energy investments can help during inflationary environments. This is because as the cost of gas for your car gets higher, your investments increase in value - essentially your investments can be designed to offset your commuting/driving expenditures.  

In closing

Inflation isn’t easy to predict, but what we can do is arm ourselves with what we know today and use it to our advantage. Inflation is low and wages are growing. If you have the opportunity to lock down fixed monthly expenses that you can afford, do so while your income continues to rise. Use this opportunity to increase your income, automate your savings and invest for your future - that might or might not be more expensive in the future. And hey, if it turns out that your future isn’t more expensive after all, then make a nice donation to a cause you care deeply about, or take a trip around the world with your friends and family. As we like to say, you have a chance to gain or lose Mana in everything you do!

Stephanie Bucko is a fee-only financial planner based in Los Angeles, California and is the Chief Investment Officer of Mana Financial Life Design. Mana Financial Life Design provides comprehensive financial planning and investment management services to help clients organize, grow and protect their wealth throughout life’s journey. Mana specializes in advising professionals in the tech industry, as well as women who work in institutional investing, through financial planning and investment management. As a fee-only fiduciary and independent financial advisor, Stephanie never receives commission of any kind. She is legally bound by her certification to provide unbiased and trustworthy financial advice.