Back to Basics: The Lessons of Inflation

We’re now over a year into a period of relatively higher inflation in the United States. This follows an extended period — decades — of relatively benign, low single digit levels of inflation. The Federal Reserve has targeted an inflation rate of 2 percent per year and has done an excellent job of coming close to the single-digit target. Until now.

Realistically, there’s no clear end in sight. From a practical perspective, we know that the Fed’s small steps, coupled with some other factors, will eventually get us back to a tolerable level of inflation.

There’s also a notion gaining traction where people realize that their experience with inflation is not exactly the same as their friend’s or neighbor’s experience. How inflation affects you personally depends on your personal situation. Not all goods and services increase in price at the same rate; some increase a great deal and others not so much. How inflation impacts you depends on your consumption mix. For example, someone who needs to do a lot of driving is more impacted than someone who doesn’t, because gas prices have increased more than other prices during this inflationary period. That difference may be further compounded if they drive an inefficient vehicle.

So, when you hear “prices are up 7 percent or so over this time last year,” you can know that you may personally be experiencing something like that, or perhaps a little less or perhaps a bit worse. It depends on your situation. Which is to say it depends on the financial choices you have made in the past. That leads us to the big lesson of inflation: Basics matter.

Why Basics Matter

Inflation reduces your real income. Your real income is a measure of the goods and services you can purchase with your income, adjusted for inflation. When the prices of goods and services increase, your income can purchase less, meaning your real income is reduced. Many companies’ cost-of-living increases are designed to counter inflation, keeping real income levels across time. That’s why those 2 or 3 percent cost-of-living increases don’t get you ahead; they help maintain, but not improve, your real income.

The basics of financial wellness help us work within the constraints of our real incomes. We need to live within our means, invest to produce real returns, and not take unnecessary risks. All these basics come into play in our personal experiences with inflation.

Living Within Your Means

Living within your means is a core financial fundamental. To live within your means is to not have a lifestyle or other expenses that are excessive for your income. Living within your means makes it easier to absorb financial shocks, such as rapid price increases. People who are living beyond their means are overextended (oftentimes using credit to fund their lifestyles), and they have no room to absorb increases. Those living within their means still feel the negative impacts of inflation, but it doesn’t cause them the amount of stress or hardship it brings to those living beyond their means.

Invest to Produce Real Returns

Your real rate of return is a measure of your investment performance, adjusted for inflation. It is only when your investments earn returns greater than the rate of inflation that you grow your purchasing power. That’s the intent of investing: that your dollars can purchase more in the future than they can today.

Equity investments may experience some weak or negative returns during periods of higher-than-normal inflation. Eventually, historically, they adjust. Companies may have some challenges adjusting to changes in costs and maintaining their profits during a period of change, but most adjust, and stock prices tend to catch up.

Investors need to be in investments that are likely to grow at a rate greater than the rate of inflation in the long term. Investments that were not keeping up with inflation before may be looking even worse now.

The fundamental is to invest to beat inflation. Now and always.

Don’t Take Unnecessary Risk

A degree of risk is necessary; the future is always uncertain. Excess risk, however, is never necessary.

Doing well financially is the result of your collective decisions. Decisions on where to work and where to live, what to drive and what to eat, what to spend and what to save. All these decisions, collectively, get us where we are today.

Excess risk comes in when we don’t weigh possible negative outcomes. Consider a couple that was looking for a new vehicle before this inflation situation came about. One wanted a large gas-guzzling truck, the other a practical — and fuel-efficient — sedan. The outcome of that decision, the evaluation of risk and reward, impacts them today. They may have a gas-guzzling truck that’s killing them with fuel bills, or they may have a fuel-efficient sedan that still costs more than it did, but manageably so.

When we look at things like the future cost of gas, we tend to be overly optimistic. A better approach is to consider the possible consequences of a large change in costs. For example, we know that gas will eventually cost $5 a gallon and will eventually cost $6 a gallon, what we don’t know is when. If we consider how such prices might impact us, we become more likely to make the best financial decision in our own circumstances. Maybe we have to drive a lot and purchase a practical vehicle, maybe we work from home and have a fantastic truck. But whatever we do, we do it informed of the possible consequences.

The Bottom Line

We all make financial decisions every day. Decisions always have consequences. If we stay within the realm of living within our means and making prudent financial decisions, adverse events in the world have less of a negative impact on us than if we are overextended and spending money we don’t have.

There is no overall good that comes from high inflation. People will suffer from higher prices, less purchasing power, and lost opportunities. The degree to which we are negatively affected is determined, at least in part, by the financial decisions we made in the past. Those who have paid attention to the basics are likely to suffer less consequences. No matter where you are, returning to the basics can help you weather the storm and be best prepared for whatever comes next.

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This article's view is the author's and does not reflect the opinion of any member of CentSai's management. The author is not being paid by any financial services company nor has been paid to promote any individual product or service. The author is not a financial advisor or a broker-dealer. The content above is education-only and any reader is encouraged to seek advice from a registered financial advisor before taking any action.