This week I am going to try and explain some complicated concepts in the markets related to inflation and purchasing power. Sometimes these issues are made complicated by the "talking heads" so I want to try and simplify the concepts and show you why it's important for your retirement.
I have been talking about inflation the last couple of months, and will most likely be talking about it for the foreseeable future. I'm not going to try and teach an advanced economics class but rather give some real world, practical examples of inflation and the impacts on your money.
What is inflation and why does it matter? First, let's define inflation. Inflation, very simply, is defined as the decrease of purchasing power due to the rise in prices across the economy. Let me give you an example...
My dad used to tell me stories about how he could go see a double feature film with popcorn, a candy bar and a pop (apparently "pop" was soda back in the day) for $0.35. Now, a movie is about $15 per person, popcorn another eight bucks and a candy bar another $5 on top of that. I left out the soda because I'm already broke...don't have enough for the soda...:).
This increase in the cost of goods can be seen across almost every level of the economy over time. Inflation is not necessarily a "bad" thing but more a natural cause and effect of a growing economy.
However, when the economy gets too "hot" inflation can get out of control, as is happening in several areas of the economy right now. For instance, lumber costs are through the roof due to high demand and low inventory. Very much the same thing is happening in the housing market right now. Low inventory, high costs. These are examples of short term inflation.
Even though prices in both areas will eventually come down, they will almost never come back to their earlier levels. For example, even though housing prices will most likely decrease somewhat, it is impossible to think we are going to buy a house in CA for $35,000 like we did in the 1970's. That is long term inflation.
Low interest rates spur further inflation due to the reduced cost of borrowing. Let's walk through an simple example in the housing market. For example, let's say the purchase price of a house is $400,000 and the buyer puts down 10% and finances the rest. That would be $360,000 financed. If that $360,000 is financed over 30 years at 3%, the payment would be roughly $1570 per month. That same balance financed at 6%, which was a great rate not that long ago, the payment is closer to $2160/month.
That lower payment makes it easier for more buyers to qualify for a $400,000 house. Simple supply and demand tells us, if there are more buyers than sellers, then prices will increase. In other words, there are more people that can afford a $400,000 house with a $1570/month payment than a $2160/month payment. That is inflation at it's most basic form. Once interest rates start to rise, the value of real estate will come down as people can no longer afford the higher payments.
So how does this apply to your retirement funds?
This same exercise can be applied to stocks, though there are a few differences. Investors, especially at the institutional level, are flush with cash right now and have very few safe places to put money and generate returns. Normally, investors would seek to place a portion of money in "safe" places to generate returns. For instance, they would buy government or corporate bonds (think G and F funds). However, bonds are not keeping pace with inflation which forces money into riskier assets....stocks.
As more money gets invested in stocks, just like the housing market, the price of stocks increases. There are more buyers than sellers of particular stocks which causes the price to rise...just like houses. That is basically what has been happening very recently, and since the 2008 crash more generally. Once interest rates start to normalize, the price of stocks will probably decrease as a result.
If you are heavily invested in stocks, interest rate normalization could have a very negative impact on your money. As interest rates increase, both stocks and bond funds will decrease (with the exception of the G fund...it is guaranteed).
I know this is a confusing topic for a lot of people but I thought it important to, at least, try and explain since it is so important for retirement planning. Rising interest rates/inflation are rarely discussed but need to be planned for. Inflation effects everything from the price of energy (gas/electric) to housing, to the price of a movie. Imagine someday paying $100 a piece for you and a grandchild to see the latest Disney movie. It's not out of the realm of possibility during our lifetimes.
I don't mean this as a doom and gloom article. Only informational. Inflation/deflation has been happening for thousands of years (look up the Roman Empire) so it is nothing new.
Like everything else, just have a plan and stick to it...
Matt
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