How Does Inflation Affect Wealth Planning?
By : Jeremy Sorci | September 30, 2017
Given the recent economic uncertainty and concerns about federal deficits, it’s easy to understand why so many clients come to us with questions and worries about inflation.
This overview helps demystify inflation by defining the concept, summarizing the consensus view of causal factors, and offering both near and long-term perspectives on future inflation trends to aid you in the wealth planning process.
How Does Inflation Affect Your Wealth Management Strategies?
Inflation is a general increase in the overall price level of goods and services over time. From 1960 through 2012, the US rate of inflation — as measured by the Consumer Price Index – grew by an average of 3.79% per year. At this rate, the purchasing power of one dollar is cut in half in approximately 19 years.
While theories as to the cause of inflation vary, general consensus points to the “Demand-Pull” theory: When demand grows faster than supply, prices rise which has also been described as “too much money chasing too few goods.” Given the recent increase in the money supply — resulting from the Federal Reserve and U.S. Treasury’s attempts to prevent a depression and support the faltering economy – many investors have grown concerned about the potential for inflation. However, research from Ron Ross, our resident Econ PhD, suggests that inflation should remain subdued in the near-term.
The slowly decreasing unemployment rate’s impact on consumer spending and wage growth, sluggish rates of factory production, and high banking system reserves (i.e. no lending) indicate that inflation concerns are more likely to be long-term.
High unemployment limits consumer spending and wage growth, leading to lower demand for products and services. Economic theory indicates that without robust demand, a sustainable, significant rise in the prices of goods and services is not likely in the cards.
When capacity utilization, or the rate at which factories produce goods relative to capacity, is high – above 82% — robust consumer demand and increased competition for production resources drive prices up. When capacity utilization rates are low – below 82% — the opposite holds true.
Banking System Reserves
At the apex of the financial crisis, fears of a systemic banking collapse ran rampant. In an attempt to avert the so-called “widespread financial meltdown,” the Federal Reserve injected huge amounts of capital into the banking system through asset purchases and outright loans.
In more normalized economic conditions, these dollars would find their way into the economy through bank lending, resulting in a significant increase in the money supply – and leading to inflation.
However, given current economic uncertainties, banks are reluctant to lend, which prevents excess reserves from entering the system and putting upward pressure on the level of prices. Should banks decide to lend those reserves, rather than let them sit collecting minimal interest, the near term inflation outlook would be more alarming.
Financial Strategies with a Long-Term Outlook
While inflation will likely be contained in the near future, the long-term outlook is more precarious, thanks to high budget deficits and the resulting threat to Federal Reserve independence and U.S. dollar weakness.
While conventional wisdom suggests that federal budget deficits – when the government spends more than it collects – are directly related to inflation rates, economic theory argues that this is only partially true. According to Keith Sill, senior economist for the Philadelphia Federal Reserve, budget deficits and inflation are only directly related in developing economies where monetary policy — interest rates and money supply – are entwined in fiscal policy, or government spending and taxes.
However, in light of the Fed’s willingness to intervene in various initiatives, such as TARP and industry-specific bailouts, some believe that the Fed’s independence is compromised.
Others argue that the Fed will have to increase its purchase of government securities in order to fund budget, resulting in an increased money supply that may result in upward pressure on prices when the economy normalizes. Additionally, some feel that the Fed’s continued efforts to prevent rising interest rates will lead to inflation.
For the past decade, the dollar has been under pressure – and this trend doesn’t seem likely to change anytime soon. A weak dollar can trigger inflation due to:
- A large trade deficit – we import more than we export, and weakened currency means that the price of imported items rises
- Commodities that are priced in U.S. dollars grow more expensive as the dollar weakens
Given the current health of the economy, hyper inflation doesn’t appear to be a concern in the near-term. However, the long-term outlook is a little less clear.