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Inflation: Questions and Answers

Inflation: Questions and Answers

September 14, 2022

It seems most times inflation is mentioned in the news, it’s usually accompanied by a reference to the fact that we have not seen these types of inflation numbers in over 40 years. And it’s true. 

According to the Consumer price index, or CPI, which is produced by the Bureau of Labor Statistics, we haven’t seen inflation at these levels since 1981 when the rate was 8.9%. The next two highest years of inflation since 1981 are 1990 when the rate was 6.9%, and 2007 with a rate of 4.1%. In each of those two years, the inflation rate significantly decreased the following year. Are we expecting inflation to drop in 2023?

 If you are not at least in your late 50’s today, the experience of higher inflation rates over a prolonged period may be something you haven’t encountered yet. Many of the financial plans prepared in the past 20 to 30 years have projected an inflation rate that hovered around 2.0% to 2.5% a year - a reasonable estimate since the annualized inflation rate for the twenty-year period from 2001 to 2021 was 2.30%. ¹ However, it would be inappropriate to estimate future inflation at the same lower rates considering the current inflation rate and economic outlook we face today.

¹Consumer Price Index


Below are some questions and responses that can help you understand more about inflation and its potential impact:

        If my living expenses continue to rise above my income, where can I withdraw the needed funds to cover the deficit?

If inflation has the effect of increasing your living expenses beyond your income, the deficit will need to come from savings or retirement accounts, from increasing debt, or from the sale of assets. Selecting the best source of funds to withdraw from requires careful analysis, especially tax considerations.


         Which sources of income will also rise with the rate of inflation?

An obvious solution in a rising price environment is to have your income rise just as fast or at least equal to the rate of inflation. Usually, during retirement, your annual income will come from different sources. Some forms of income will increase each year with changes in the cost of living, otherwise known as cost-of-living adjustments (COLA). These adjustments are usually tied to CPI or some other comparable variable. The more of your income payments that contain COLAs, the better hedge you have against rising inflation, short or long-term. But if you have annual income payments that do not contain cola’s, a persistent higher inflation rate could force a change in spending or accelerate withdrawals from other sources much faster than you may have planned. 


          Are raising interest rates the only solution to combat rising prices?

The Federal Reserve has a few monetary tools at its disposal to slow down rising prices, but none may be as effective as raising interest rates. The Fed essentially needs to slow down consumer demand. Raising interest rates will reduce borrowing by businesses and individuals which has the effect of lowering the money supply and eventually decreasing spending and hiring.


       Won’t raising interest rates slow down the economy?

Probably. The Fed has made it directly and subtly clear it will sacrifice slower economic growth (higher unemployment) to ensure inflation is under control. A harsh statement considering through March of this year, the Fed was still injecting approximately $150 billion a month (increasing money supply) into the U.S. economy through bond purchases, while prices for items ranging from toothpaste to airfares were steadily increasing. 


     What choices do investors in capital markets have during high inflationary periods?

If you are invested in the capital markets (stocks, bonds), you most likely understand that possible high inflationary periods are one of the conditions we accept when investing in the markets. The acceptance of additional risk (uncertain conditions) provides the opportunity to earn higher investment returns.


If you are a disciplined investor, you realize that there may be a temporary market decline and inflation may persist longer than expected. The attempts to time the market or select which stocks or sectors will perform better during inflationary periods is a transaction-oriented approach to investing which can add more risk. Increasing risk, in most cases, is what people in retirement should be avoided due to shorter time horizons and their greater emphasis on asset preservation.

Accepting the potential loss in purchasing power due to an 8.0% to 9.0% inflation rate and potentially experiencing lower market returns is an unavoidable part of long-term investing. Historically, the markets have rewarded long-term investors for the risk they accept through many domestic and global events, including 1980's inflation


 Does inflation materially impact my financial plan? 

If you already have a plan, it may be a good idea to review the strategies and assumptions that you’re employing to accomplish your financial goals. The straightforward planning objective of “Can I afford my financial goals in the future?” has possibly become more difficult to accomplish due to the rising costs of goals.

If you haven’t created a financial plan, it may be a good time to do so. There are many variables and uncertainties to deal with in planning for your future, and inflation is certainly one of the more critical ones.  

Please visit my website for further information about my company's services and its educational resources. And of course, please feel free tocontact us if you have a question or would like to schedule a no-charge initial consultation. 

Anthony B. Carr, CPA, CFP®, MBA


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