Six things you need to know about inflation

The U.S. economy’s rebound from the pandemic is driving the biggest surge in inflation in nearly 13 years.

You might be wondering whether that increase will affect your finances now — or in the future.

The good news: Recent price increases are unlikely to have a significant adverse impact on your finances. (or financial well-being). 

Over the long term, however, inflation could eat away at the value of your money. That likelihood could present a problem for assets like your retirement savings, which you’re counting on to support you years in the future.

Here are six things all long-term investors should know about inflation:

1. How is inflation measured?
Inflation refers to the increase in the prices of goods and services over time. While there are many ways to measure inflation, the most relevant measure for most people is the Consumer Price Index (CPI) used by the U.S. Bureau of Labor Statistics (BLS). Every month, the BLS surveys 23,000 businesses to log price fluctuations in goods and services — everything from retail goods and food and gas to healthcare, housing and education.

2. What causes inflation?

Inflation has two main causes:

1. Increased demand. When the demand for goods and services increases, suppliers often respond by raising prices. Compelling marketing, new technology, a growing economy, government policy and the expectation of future inflation can all increase demand or raise prices.
2. Reduced supply. A shortage in supply, coupled with steady demand, can also lead to inflation. This type of inflation sometimes occurs when wages rise. It can also be caused by government regulation and taxation and/or a decline in currency exchange rates.

3. What are the effects of inflation?

When inflation happens, the purchasing power of the dollar goes down. In other words, your money becomes less valuable.

Inflation impacts different groups in different ways. It can be especially harmful for:

• Those with lower incomes. Lower-income populations spend a high proportion of their income on basic necessities, so they don’t have a lot they can cut back on.
• Businesses working on fixed contracts. These businesses may suffer big losses from inflation because they can't pass along higher prices to their customers.
• Retirees. Many retirees rely on savings and fixed sources of income such as pensions. Inflation causes their money to be worth less.

Not everyone suffers from high inflation rates, though. It can actually help some people and organizations, including:

• Those who owe money. Inflation essentially makes money cheaper to pay back — as long as your debt doesn’t continue to increase.
• Homeowners. Costs generally don’t rise as much for those who own their own home.
• Governments. Governments tend not to mind some inflation because it makes debt look cheaper.

4. How does inflation affect investment returns?

Most investors want to increase their long-term purchasing power. Inflation puts this goal at risk because investment returns must first keep up with the rate of inflation. For example, an investment that returns 2% before inflation in an environment of 3% inflation will actually produce a negative return (−1%) when adjusted for inflation.

If investors do not protect their portfolios, inflation can be harmful. Many investors buy fixed-income securities (bonds) because they want a stable income stream, which comes in the form of interest payments. However, because the rate of interest, or coupon, on most fixed-income securities remains the same until maturity, the purchasing power of the interest payments declines as inflation rises. In addition, inflation typically leads to rising interest rates, which erodes the value of the principal on fixed-income securities.

Unlike bonds, some assets increase in price as inflation accelerates. Price increases can sometimes offset the negative impact of inflation. This outcome is particularly true for:

• Stocks. Stocks have often been a good investment relative to inflation over the very long term: Companies can raise prices for their products when their costs increase in an inflationary environment. Higher prices may translate into higher earnings.
• Inflation-linked bonds. These bonds, which are issued by many governments, are explicitly tied to changes in inflation. For example, Treasury inflation-protected securities (TIPS) are issued by the U.S. government and pay a nominal rate of interest plus the annual rate of inflation as measured by the CPI.
• Floating-rate notes. These assets offer coupons that rise and fall with key interest rates. The interest rate on a floating-rate security is reset periodically to reflect changes in a base interest rate index, such as the London Interbank Offered Rate (LIBOR). Because of this link, floating-rate notes have been positively correlated with inflation, meaning their returns have tended to rise when inflation increases and fall when it declines.

5. How concerned should I be about recent increases in inflation?

In May 2021, consumer prices rose by 5% from a year ago, the largest increase since August 2008. And the core-price index, which excludes the often-volatile categories of food and energy, jumped 3.8% in May from the year before — the largest increase for that reading since June 1992.

May’s jump in prices extends a trend that accelerated this spring amid widespread COVID-19 vaccinations, relaxed business restrictions, trillions of dollars in federal pandemic relief programs and ample household savings — all of which have stoked demand for Americans to spend and travel more.  What we are experiencing now is a rare combination of both types of inflation. The full-stop of the economy last year created significant supply shortages that need to be resolved before prices can normalize.

That said, you probably shouldn't be overly concerned. Recent inflation measurements are being boosted by comparisons with figures from last year during pandemic-related lockdowns, when prices plummeted because of collapsing demand for many goods and services. This effect, known as the “base effect,” is expected to push up inflation readings significantly in May and June of 2021, with those readings expected to dwindle this fall. To put current inflation into better perspective, keep in mind that overall prices rose a modest 2.5% in May compared with two years ago. 

6. What will happen next with inflation?

Policymakers are watching inflation numbers closely. Many expect several months of stronger inflation after a year of very weak price pressures during the worst of the pandemic.

Whether the pickup in inflation proves temporary is a key question for the U.S. economy and financial markets. The Biden administration, Congress and the Federal Reserve are expected to continue to support the economy with policy measures aimed at keeping inflation in check.

All statistics above are from the U.S. Bureau of Labor Statistics unless otherwise noted. The research, views and opinions are intended to be educational and are not tax, legal, accounting or investment advice.