What You Need to Know
- To protect savings from getting eaten away by inflation, it's best to invest in riskier assets, and diversification will be key.
- Retirees are normally the most harmed by inflation because they live on a fixed income, but Social Security is indexed to inflation.
- While 4% inflation isn't what it used to be, this is a new economy.
If you are under 45 and live in America or Europe, the odds are this past year has been your first real experience with inflation. Other than a blip in 2008, inflation has barely topped 3% in the last 30 years.
But now inflation is back; up more than 8% last month, and it may get worse before it gets better. Some of the drivers of price increases today, supply chain disruptions and war in Ukraine, will eventually abate.
But there are reasons to believe we aren’t going back to 2% inflation anymore. The economy is different and the new baseline for inflation will be 4% or 5%.
Americans used to get along just fine when higher inflation was the norm. But the world is different now; 4% poses new costs and benefits to a new generation.
So what does it mean for living your life or conducting your business if inflation hovers between 4% and 5% instead of the 1.5% to 2.5% we’ve taken for granted for so long?
To paint that picture, we need to assume a reasonable degree of stability. If inflation is higher, but remains in a tight range, it won’t cause too much damage. The average inflation rate was 4% or 5% for many years and the economy still grew.
That said, much has changed since the late 1980s when inflation hovered around 4%. That rate is almost twice what people now are used to, and all segments of the economy will have to adapt.
Getting a pay raise was less critical when inflation was 1% or 2%. Employers got used to giving smaller increases. The last time inflation was high, unions negotiated annual cost-of-living raises built into the pay of many workers.
Now most will need to demand it for themselves. For workers who don’t — or can’t — negotiate raises that keep pace with inflation, their real compensation will shrink each year as their pay is worth less.
Even if you do get a decent raise, those increases generally come just once a year, while inflation happens continuously, eating away at your buying power.
Companies won’t get off easy either. They’ll face higher costs for labor, rent and the goods they use. They will need to increase their prices more frequently, which risks alienating their customers.
It puts smaller firms at a disadvantage, shifting demand to large companies with fatter profit margins that can afford to absorb some of the inflation so that they pass on less of the pain to the consumer.
Inflation will be a bigger problem for small business than it was in the 1980s because big firms dominate the market now — odds are your local mom-and-pop hardware store is already barely hanging on against Home Depot.
The online marketplace that brought prices down by increasing transparency will continue to make it harder to raise prices above competitors, which will be another strike against small companies.
Interest rates will go up because the Fed will raise rates to keep inflation in check, and investors will demand higher rates to compensate for inflation. That will mean more expensive mortgage loans.
That would usually weaken housing prices, but as long as demand outpaces supply — which we’re seeing now — and if the rental market continues to go up, you can’t count on housing prices falling.
However, if you already own a home with a fixed-rate mortgage, your wages will go up, while your monthly mortgage payment will stay the same, meaning your real housing costs will fall (though not your property taxes or upkeep costs).