Today’s inflation is not like your father’s or even your grandfather’s inflation. In 2020, the global COVID pandemic caused the economy to contract quickly; businesses were forced to close, and millions of people lost their jobs. The economy was at risk of completely deflating. The Federal Reserve responded by pumping money into the economy. Congress and the White House offered trillions of dollars to families and businesses. Beginning in 2021, the economy recovered — but it grew too quickly. People started spending more money than anyone expected. Coupled with supply chain issues around the world, this consumer demand caused everything to become more expensive. Rather than cutting back because of high prices, consumers continued to spend at higher prices, driving inflation even higher. Then, earlier this year, Russia invaded Ukraine which created a new supply chain disruption, including driving up the price of natural gas, oil, and wheat.
We typically think about inflation as “too many dollars chasing too few goods”. For the past four decades, the primary tool to address this issue was “demand destruction,” where the Federal Reserve increases short-term interest rates. This effectively increases the cost of capital, which shrinks the money supply — the “too many dollars” — and lowers inflation. Currently, there has been considerable debate as to the expected effectiveness of this tool, as it relates to today’s problems. These are not normal times, and high inflation is not limited to the U.S. If the Federal Reserve raises rates too fast, it could hurt the economy. But if rates are not raised enough, inflation could go even higher. The Federal Reserve has a history of overreacting to these interest rate hikes, choking off economic growth, and sending the economy into a recession (New York Federal Reserve Recession Probability Index).
Uncertainties, Unintended Consequences, & What to Watch for
Some components of today’s inflation are more “sticky” like increasing wages from a very low unemployment rate (partly driven by demographics of a declining workforce) and rents as leases mature over time at higher market rates. Some components of inflation are just out of our control. Recent external open-ended exogenous events (Russia, labor participation, & supply chain issues) that have also helped fuel inflation are not expected to be impacted by the Federal Reserve’s increase in interest rates, and the timing of the resolution of these events is largely out of our control and could come at a time when the Federal Reserve has overcorrected, thus magnifying their anticipated deflationary impacts (this is the hard landing scenario).
Today’s inflation is a global problem, and how central banks respond is likely to produce unintended and potentially conflicting consequences. The United Nation’s annual trade and development report cautioned that the increase of interest rates by the central banks of the richest countries was expected to cut an estimated $3.6tn of future income for developing countries and could cause an emerging market debt crisis. Basically, higher US interest rates increase the value of the US dollar, which tends to increase the level of poverty in the third world by exporting US inflation.
The market will remain volatile as central banks evaluate and adjust their interest rates. As we observed in July, just a few comments by Fed Chairman Jerome Powell fueled a rise in stock prices, which ended after the Fed reaffirmed its commitment to increasing interest rates to combat inflation in late August. Just this week, the bank of England called an emergency meeting to pause quantitative tightening and temporarily pivot to quantitative easing because of the stress it posed to the UK pension system in the face of an expected 11% inflation rate. The Federal Reserve continues to reduce its balance sheet through quantitative tightening which includes selling residential mortgage-backed securities it holds. This has contributed to a rise in the interest rate on a 30-year mortgage to over 7%. This has led to the largest two-month decline in medium home prices since January 2009. We will have until November 2nd to see if the Federal Reserve will raise, pause or pivot policy (interest rates). The current expectation is another raise in interest rates.
What this means for you and your retirement planning
When it comes to retirement planning, inflation is a critical factor to determine:
- How much you will need to live comfortably in retirement;
- Whether you may need to alter the amount you divert to savings to achieve your retirement goals and
- Whether your investments will keep up with inflation without taking undue risk.
If you own a business, you may be under pressure on multiple fronts. Many of your costs are likely increasing. The employees you have are not immune to the corrosive effects of inflation and may be demanding higher wages. Businesses haven’t been immune to rent increases either as many landlords have increased lease rates to whatever the market will bear. Budgeting and forecasting become critical necessities during times of economic uncertainty as inflationary pressure can drive a business underwater quickly.
During times of high inflation, we recommend that clients re-evaluate strategic planning for retirement. It is a good time to talk to your financial advisor and potentially update your financial plan. A review of your investments is also a good idea in today’s economic environment of high inflation and a flat inverted yield curve.
For business owners or managers, budgeting, forecasting, and managing your cash flow is more important than ever. You need current and accurate financial information is needed to make a timely evaluation of business decisions.
You should consider adding a “dashboard” to your financials to allow management to know how much your prices need to go up, to pass on the inflation without impacting your profit margins or causing your business to fall out of compliance with bank loan covenants.