In early 2021, the U.S. government rolled
out another massive round of economic stimulus aimed at offsetting the damage done by the
COVID-19 pandemic. But there’s a potential side effect that
some investors and economists fear could actually hurt the economy even more: inflation. Inflation is the rise in cost of goods and
services. Basically, it’s how much your money loses
value over time. Many economists believe inflation isn’t
all bad; it typically goes hand-in-hand with economic growth. And too little inflation, known as disinflation,
or falling inflation called deflation, can be a sign of a struggling economy. But too much inflation too quickly, called
hyperinflation, can lead to economic instability and market crashes. While many policymakers and economists think
hyperinflation as a result of economic stimulus is unlikely, others aren’t so sure. Understanding what causes inflation, how it’s
measured, and how the government manages it can help you take steps to prepare your portfolio. So, what exactly causes inflation? The most common theory is based on supply
and demand. Basically, the more money there is in the
economy, the less it’s worth, and vice versa. In order to stimulate economic recovery from
the COVID-19 pandemic, the Federal Reserve and the federal government did things like
cut interest rates and send checks to encourage Spending essentially creating money. You can see it in the M2, a calculation the
Fed uses to track the money supply. It grew from about $15.5 trillion to more
than $19.6 trillion from February 2020 to February 2021. This degree of growth is unprecedented in
the United States. Some worry that the more money the government
floods into the economy, the less each dollar will be worth, starting a spiral toward hyperinflation. The closest the United States came to hyperinflation
was during The Great Inflation from 1965 to 1982. During this time, there were four recessions,
two energy shortages, and wage and price controls. The Consumer Price Index, or CPI, which measures
inflation by tracking the prices of common goods like food, housing, clothing, transportation,
and more, hit a high at one point of nearly 15% year over year growth. The higher inflation translated to higher
interest rates. Mortgage rates climbed to 18.63%. And the unemployment rate climbed to 9.7%. All these factors led to a stagnant stock
market; the Dow Jones Industrial Average struggled to move above the 1,000 level for nearly two
decades. So, should you be concerned about hyperinflation? Many economists and policymakers think the
risk is low. In March 2021, Federal Reserve Chairman Jerome
Powell testified before Congress that deflationary pressure over the last 25 years should help
offset the risk of inflation. One deflationary pressure is productivity
and efficiency gains from technology and globalization. Advances in computing, telecommunications,
and networking have elevated productivity and kept labor costs low. And global free trade has let companies seek
lower cost materials and labor abroad and use just-in-time production systems
to avoid the cost of storing inventories. As a result, employment has been relatively
soft since the Great Recession and took a major hit from the pandemic. In January 2021, long-term unemployment was
approaching 2010 levels, and wage growth for many workers has been underwhelming. Finally, slower economic growth has helped
keep inflation low. Since 2000 and prior to the COVID pandemic,
annual U.S. Gross Domestic Product, or GDP, a measure of income for a country, has stayed
below 3% annually, keeping inflation low with it. Considering all these factors, many economists
and policymakers see plenty of room for the economy to grow before reaching dangerous
levels of inflation. However, despite low overall inflation, there
have been pockets of rising prices. For example, in late 2020 and early 2021,
supply chain disruptions and high demand caused lumber prices to rise more than 170% in just
10 months. The rising costs of lumber is adding $24,000
to the price of a new home. In February 2021, food inflation for the previous
year was 3.5%. Some of this was due to supply chain disruptions
but also rising oil prices, which increase the cost of transportation. In March 2021, the CPI rose 0.6% for the month
and was up 2.6% from the previous year. Much of this was driven by a 9.1% spike in
gasoline prices. Remember that inflation is part of normal
economic growth. Traditionally, the Federal Reserve has an
inflation target of 2%. Chairman Powell said the Fed will allow inflation
to run hotter than normal to spur economic growth. Powell and Treasury Secretary Janet Yellen
have both said the risk of hyperinflation was small and that the government has tools
to address inflation if it does occur. However, former Treasury Secretary, Larry
Summers, is less optimistic and pointed to the Fed’s past inability to slow an overheated
economy without causing a recession. Harvard economist Greg Mankiw warned that
the economy may overheat if inflation exceeds 3% for the next five years. If you’re concerned about how inflation
could impact your investments, there are a few things you can do. First, remember that historically speaking,
stocks have tended to outpace inflation over the long run. From 1926 to 2020, inflation has averaged
2.9% a year while stocks have returned an average of 10.3%. This is well above bonds and cash. Of course, past performance is no guarantee
of future performance. Next, consider value investing, Value investing
is a strategy that selects stocks that appear to be underpriced, as opposed to growth investing,
which selects stocks whose prices are based on high expectations for future growth. In the event of hyperinflation, borrowing
costs may rise. This may hurt growth companies, which tend
to rely more heavily on debt, while value companies are less likely to borrow to produce
future earnings. Also consider TIPS, or Treasury Inflation-Protected
Securities. An initial investment in TIPS increases with
inflation as measured by the CPI. In other words, if the CPI rises, the value
of the principal invested in TIPS and future interest payments will rise as well. When TIPS mature, an investor is paid the
adjusted principal or original principal, whichever is greater. Of course, TIPS are subject to certain risks. They tend to have lower yields than other
treasuries, their value will decline if interest rates rise, and principal adjustments can
be taxed before the bond is sold or redeemed. Whether you’re concerned about hyperinflation
or believe the Fed will be able to keep it under control, it’s important to monitor
inflation and take steps to help protect the purchasing power of your money.
This guy did a hell of a job describing explaining and actually simplifying it so people would be able to understand it better.