What is all the buzz about inflation?

What is all the buzz about inflation?

When I graduated college, one of my best friends sent me a vibrator in the mail. When it arrived, she called me and was like “Dude, you need to hear this thing.” I was horrifically embarrassed, especially since I had a new guy as a roommate, but she was adamant that I turn it on. So… I went to my room and pressed ‘ON’. This thing was not only loud, it was a freight train. A buzz so deafening, you could hear it from the other room (as confirmed by my roommate’s face when I finally emerged a few minutes later). His only response, “Did you need help drilling something?”

Needless to say, I locked the murmuring menace away for a few years until I moved to San Francisco. During the move, a friend was helping me unpack and low and behold the vibrator fell out. I told her, “This is the loudest thing I’ve ever heard. You will not believe it.” So, I pressed the button… To my surprise, it let out nothing more than a whisper. I was shocked since just a few years prior it was piercing through locked doors. Which leads me to my main point – just because something is powerful doesn’t mean it can’t lose it’s steam. 

WTF is Inflation?

Inflation is the rise in average prices in an economy. Ever wonder why your grandpa paid $250 for college and you paid $250,000? Inflation. 

How does it work?

The more prices (food, houses, clothing) rise, the greater the rate of inflation. Government statistical agencies such as the US Bureau of Labor Statistics measure inflation by calculating how the prices of items change from one period to the next. In the US, the reference used to calculate the US consumer price index (CPI) has over 200 categories of goods and services purchased by households and businesses. They are divided into 8 major groups (food and beverages, housing, apparel, transportation, medical care, recreation, education and communication). 

What causes inflation?

Too much money chasing too few goods and services. 

Example: Let’s say there is a new trendy store in your neighborhood. Everyone you know is obsessed with the clothes and they are all in your price range; however, each time you go, the clothes you want are sold out. Well, that’s because everyone can afford the clothes and everyone wants them. The clothing store now decides to get smart, and raise their prices given the higher demand. I call this micro inflation. 

In today’s world, we’re seeing similar spikes in demand with certain commodities such as lumber and semiconductors. By now, you may have seen the memes. In regards to lumber, there has been a spike in home ownership causing demand for home improvement projects to jump; as a result, the demand/price for wood to go up. Similarly, semiconductor demand and price has been increasing due to the increase of demand for electronic devices. So if you’re wondering why your iphone keeps getting more expensive, that’s exactly why.

Who controls it?

The Federal Reserve (The Fed) tries to control inflation. Key word: tries because inflation is highly driven by the CPI. They seek to control inflation by influencing interest rates (currently they are targeting 2% inflation).

When inflation is too high, the Federal Reserve typically raises interest rates to slow the economy and bring inflation down. Similarly they lower interest rates to stimulate the economy and drive inflation up. Wonder why interest rates dropped so low during the pandemic? Well, the gov was trying to stimulate our suffering economy and encourage people to borrow/spend. Did I personally buy anything in San Francisco? No, but I certainly got on Zillow more often.

So, how do they control interest rates? They control the money supply. If you want interest rates to rise, you decrease the money supply (aka, money gets more scarce/expensive). If you want interest rates to decrease, you increase the money supply (aka, money gets more abundant/cheaper). Thus, low interest rates tend to result in more inflation. High interest rates tend to lower inflation. So, if you are wondering why everyone is so concerned about inflation right now, it is tied to our super low interest rates and increased demand for goods/services.

Why does it matter to you?

Buying Power – Inflation affects your buying power. As inflation rises, the value of your dollar decreases. Think about the vibrator example. In 2015, that puppy had POWER. But by 2020, most of the steam was lost and the battery died. Your money similarly loses power over time. When I was in grade school (around 2007), I used to go to Potbelly all the time and would always order a turkey on wheat. At the time, that sandwich cost $6.50. Today, the same sandwich costs $10.42. I know because I ordered one a few weeks ago and was like… WTH. The sandwich itself has not gotten astronomically better, but inflation has driven prices up and my buying power down.

Savings – Inflation affects your bank account. If you’re ever wondering why I scream “GET A HIGH YIELD SAVINGS ACCOUNT!!”, this is exactly why. Your money actually decreases in value every year unless you invest it appropriately.

Rent – The reason your landlord raises rent every year is because of inflation (well a part of it). While I’ve always cowered at my landlord for raising rent, they also have to keep up with inflation and do so by increasing your rent.

Salary – One of the major reasons you get raises is to keep up with inflation. Now, I’m not saying you don’t deserve that raise but companies aren’t just paying you more because they love you. If you don’t get a raise (and your salary stays the same), you are actually making ~2% less than the year before. So if your employer isn’t raising your salary, time to go knock on someone’s door and ask for one.

How you can prepare for it

Invest – The reason we invest AT ALL is to beat inflation – you want the value or your money to be worth the same or more than it is today in the future. In fact, I use the 2% inflation rate as a benchmark for all my investments. While it would be nice to beat the S&P 500 every year, you should at least attempt to beat inflation.
Example: If you put $1,000 under a mattress and inflation is targeting 2%, each year you could be losing 2% of your buying power.
So if you literally take anything from this article, it’s that AT A MINIMUM, you should be trying to beat inflation. Because if you don’t think about this today, you will lose over the long term. Remember when $20 felt like a lot of money as a kid, well it’s not just because you were a kid, it’s because $20 meant more 10 years ago than it does today.

TIPS – You could consider investing in TIPS: a special type of Treasury bond that’s indexed to inflation. TIPS also come in a variety of assets like mutual funds, ETFs, and bonds but essentially they have built in protection from inflation (but always remember, nothing is guaranteed when investing). Some tips here: https://etfdb.com/etfs/bond/tips/

Commodities – You could consider investing in commodities. Typically as inflation rates rise, commodity prices rise (think about the lumber and semiconductor example earlier in this article). 

Real Estate – You could consider investing in real estate. Many flock to real estate in inflationary periods. This is because rising prices can increase the resale value of a property. In addition, real estate generates rental income. Just as property values can rise with inflation, so can rental income.

Diversify – While I could go on giving you other ideas like bitcoin, value stocks, futures, etc., IMO there is no better way to prepare for inflation than diversification. You just want to position your overall portfolio so that the average rate of return is higher than inflation in the long term. If picking stocks, bonds, and other alternatives is not your jam, find an advisor or robo advisor whose job it is to make these active adjustments for you.