What You Need to Know
- Many investors and advisors fall victim to the money illusion by focusing too much on change in assets instead of change in spending power.
- I bonds provide higher returns than TIPS.
- An even better deal on inflation-protected income: waiting to claim Social Security.
Inflation jumped 7% in 2021, as measured by the consumer price index for urban consumers (CPI-U). Price increases for goods ranged from stratospheric (51% for gasoline) to “meh” (1.6% for dairy products).
For the most part, inflation followed a sharp post-vaccine increase in transportation as Americans returned to work. However, other price increases, such as increases in the price of beef (18.6%) and pork (15.1%), are the result of supply chain and labor shortage issues that have plagued the global economy.
Understandably, the reemergence of inflation is upsetting to many Americans. Huge price increases in red meat, cars, and gasoline (so-called “manflation”), and far more modest price increases among many other consumer goods and services reflect the idiosyncratic nature of the 2021 rise in consumer prices.
When inflation rates are uneven among goods and services, this creates opportunities for consumers whose budget is more flexible to hold off on buying a new car, delay a cross-country trip, or swap chicken (up 9.5%) for beef.
Retirees who don’t need to commute can likely weather today’s inflation storm more easily than workers. And many of the expenditure categories that rank high on a senior’s budget, such as medical services (2.5%) and prescription drugs (0.0%), weren’t affected at all.
The Money Illusion
Investors flush with an unprecedented inflow of cash during the pandemic increased their investments in money market assets by 20% from $3.63 trillion to $4.33 trillion in 2020. These cautious investors saw their purchasing power drop by at least 6% in 2021.
After decades of modest prices increases, Americans are rediscovering a source of risk that many had forgotten existed. We can lose purchasing power if our money buys less stuff.
It’s not uncommon for advisors to dismiss inflation risk as a historical artifact long ago tamed by central banks. The tendency to focus more on the change in our balance sheet instead of the change in our potential lifestyle is a phenomenon known as the money illusion.
A retiree with $1 million invested in corporate bonds on Jan. 1, 2021, had about $985,000 on Dec. 31, 2021 after a modest loss. But they could only buy $916,000 worth of goods and services. This is a much greater loss.
Imagine planning for a vacation in England in June. You’ve set aside $4,000 in a checking account to pay for 3,000 British pounds worth of hotels, fish and chips, and lukewarm beer. Between January and June the exchange rate shifts, and suddenly it takes $5,000 to pay for your vacation.
Even though you still have $4,000 in the checking account, you’ve taken on a new form of spending risk by not protecting yourself against the price change that is no different than an investment loss.
In 2019, Boston University economist Zvi Bodie and his co-author, the late Dirk Cotton, made the point that planning a retirement using nominal dollars rather than after-inflation dollars is no different than speculating on the future value of a foreign currency.
A retiree who planned to spend $50,000 in 2022 speculated earlier that $50,000 nominal dollars would be enough to pay for the lifestyle they hoped to lead. They gambled on modest inflation and got unlucky.
In a 2014 Harvard Business Review article, Nobel Prize winning MIT Professor Robert Merton compared the near-zero perceived volatility of a Treasury bill portfolio to the volatility in the amount of after-inflation income a retiree could buy from their T-bill investment.
While the asset value of T-bills is flat, the amount of after-inflation income they can buy with a stable nominal income jumps up and down over time. Merton made the point that inflation risk is no different than risk in nominal investment returns.
Many investors and advisors fall victim to the money illusion by focusing too much on change in assets instead of change in spending power.