Understanding Inflation in 2021: What Investors Need to Know

Following a year of economic instability, it appears that many of us are turning our attention to something that’s been around for decades but has recently piqued national interest: inflation. Google’s search tracking shows that people are searching the word inflation at a rapid pace, with May showing the highest rate since the company began tracking searches in 2004.1

Since the start of the COVID-19 pandemic, six major stimulus bills totaling around $5.3 trillion have passed. With these efforts to alleviate pandemic-fueled financial strife, are inflation levels being impacted?

Federal Reserve Chair Jerome Powell has said that inflation is likely to pick up as the economy recovers from the pandemic, but he believes it will be temporary.

“By inflation, we mean year after year after year prices go up,” Powell said. “If something is a one-time price increase ... you wouldn’t react to something that is likely to go away.”

“We really do believe,” he added, “that these things will come down of their own accord.”²

While some amount of inflation is not necessarily a bad thing—the Fed targets an average 2% rate for a healthy economy—high inflation rates can have a significant impact on your financial plan.

Here are some important reminders about inflation and how it can affect you and your investments.

What Is Inflation?

Inflation is not simply “rising prices,” but is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics releases the Consumer Price Index (CPI) to track these fluctuations. While there are many indices tracking inflation, this is the one most commonly quoted, so it is important to understand what it measures.

Understanding the Consumer Price Index

The CPI is developed based on information provided by sellers of many types of goods and services, such as:³

Food and beverages
Housing
Energy
Apparel
Transportation
Medical care
Recreation
Education
Communication

While it’s the most commonly used indicator of inflation, it can be important to scrutinize the details. For example, the CPI rose 5.4% between July 2020 and June 2021. However, a closer look at the report shows the movement in prices on various goods tells a more nuanced story. Food at home (i.e. groceries) only rose by 0.9% Used car and truck prices and gasoline, on the other hand, each rose about 45% during those 12 months.⁴

Investments & Inflation

Inflation can affect investments in several ways. Most notably, it can reduce the rate of return, risk purchasing power, and influence the Federal Reserve.

Rate of Return

Inflation reduces the real rate of return on investments. Say an investment earned 6% over 12 months, while inflation averaged about 2%. That would mean that your investment’s real rate of return (change in purchasing power) would have been about 3.92%, not 6%.

Purchasing Power

Of course, inflation can put your purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer goods and services. If wages keep up with inflation, this can have little impact on the spending of people in the workforce. Most pensions, however, have little or no cost-of-living adjustment, so high inflation can harm retirement sustainability.

What About the Federal Reserve?

Keeping inflation near a specific target is a significant objective of Federal Reserve policy. The Fed has several ways to reduce the amount of money in circulation. Theoretically, at least, this reduces spending, leading to lower prices, hence lower inflation.

However, the Fed is not the only factor affecting the money supply. Government spending, for example, weaves an impenetrably complex web that can influence prices as well. Still, the economy does not necessarily follow the oversimplified idea that increased government spending leads directly to inflation.⁵

With so many changes over the past year or so, it’s no wonder investors and consumers are concerned about the current rate of inflation. And after recent years, when inflation has been low, it’s easy to overlook how rising prices can affect a household budget. But observers have noted that the apparent leap in prices is due in part to their having been pushed downward as the pandemic picked up steam in 2020.

Even in more ordinary times, higher inflation may tempt you to make changes to your financial standings and portfolio. If you’re concerned about inflation rates, your trusted financial advisor can help determine whether changes need to be made, or if you and your portfolio are already well-prepared.

Do you have additional questions or concerns about inflation? Set up a call today.

This content is developed from sources believed to be providing accurate information and is provided at least in part by Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information and should not be considered a solicitation for the purchase or sale of any security. Original content of Practical Financial Planning, Inc. only is copyright © 2021by Practical Financial Planning, Inc.