By Jeff Stoffer
Learn more about Jeff on NerdWallet’s Ask an Advisor
Last month I talked about the rising cost of a favorite bottle of French wine. Only six dollars thirty years ago, the same bottle now costs $20. Assuming steady inflation, it could cost over $60 in 2044. I joked that the solution to the inflation problem is not to drink more wine now while it’s cheap. A friend responded, “That made me laugh, until I realized I might not be able to afford it in the future!”
The effects of inflation really hit home when we stop working and expenses increase faster than income. You might ask, how do I “know” inflation will continue in the future. Last month, I cited some statistics on historical inflation. This month, I’d like to examine some of the factors driving inflation.
The U.S. Federal Reserve wants our economy to experience inflation. You may have heard the terms “quantitative easing” and “zero interest rate policy.” In plain English they mean, respectively, “printing money” and “keeping interest rates really low.” These policies, implemented in response to the recent financial crisis, are intended to restore growth and to battle deflation, the risk that prices fall (which is a much worse can of worms.) While they have helped avert a nasty deflationary spiral, employment growth is still insufficient. The Fed intends to continue these policies until the desired effect is achieved: more jobs and higher inflation.
The federal government also wants to encourage inflation. In the downturn it borrowed money to stimulate growth in the economy. Over time inflation decreases the value of the money borrowed. Inflation is good for borrowers and bad for lenders (bondholders.) Think of the bottle of wine. I borrow $20 to buy a bottle today. I pay interest every year (like a bond) and pay back the principal, $20, years later. By the time I pay it back, the $20 doesn’t buy as much as it did when I borrowed it, due to inflation. From the government’s point of view, inflation functions to reduce the debt burden. Pretty clever, huh?
While the Federal Reserve and the government use inflation to their advantage, it hurts savers, bondholders and those living on “fixed incomes.” The effect is called “financial repression.” People who were doing OK living on the interest from savings and CD’s know well what this term means. Effectively, their “fixed income” is worth less than it was ten years ago when interest rates were much higher. The low interest rate environment also means the rates we are earning on bonds are depressed, or rather, “repressed.”
These powerful forces ensure that inflation will continue. Like an invisible tax, it erodes our purchasing power, putting us at risk for running out of money later in life. As the pace of economic activity increases, the money printing of the last few years will turn up the burner on inflation. If the Fed doesn’t manage things well, the rate of inflation could be even higher than we estimate. Our best defenses are planning and wise investing. Plan ahead, keeping inflation in mind, and invest in assets that will appreciate in value over time.