It’s difficult to find a business news program that isn’t focused on the rapidly rising prices most consumers are currently facing. The combined impact of the waning (but still present) pandemic and the overseas conflict has caused supply issues across the globe, which has resulted in a vicious bout with inflation.
Below, we’ll go through a basic definition of inflation, its primary causes, how retirement savers might think about responding to inflation, and the reappearance of the once-passed-over I-bond.
Inflation refers to the general rise in prices throughout an economy. Over the past year, we’ve seen prices rise 7.9% from the year prior, which is the highest single-year increase since the 1970s. That’s over forty years, so it follows that most millennials and all of Gen Z have yet to experience such an environment.
In short, inflation has the unpleasant effect of eroding your purchasing power; when inflation is hot, your dollars buy fewer goods and services than they did previously. At the same time, wage growth hasn’t matched inflation, which ensures that households across the country really feel the effect.
Inflation is generally caused by unmet demand, which, according to basic principles of economics, causes prices to rise. Given the shortages we’ve endured since the start of the pandemic, demand has well outstripped available supply in many segments of the global economy, and we’ve seen an inflationary environment that’s been largely absent since the disco era.
As the cost of goods and services has increased dramatically over the past year, there is some concern that retirement savings balances won’t go as far as they once did, and that the prospect of working longer than expected is now on the table. This concern has some validity, especially if retirement is on the horizon within the next few years. For pre-retirees, couple higher inflation with the recent market correction, and there is some reason to feel discomfort.
On the other hand, the majority of people saving for retirement are many decades from drawing on their savings. For this population, a single year’s worth of inflation data won’t mean much in the long run, but it’s certainly worth keeping an eye on. As goods and services throughout the economy become more expensive, and a year’s worth of data turns into a decade of trend data, the need to either save more or to work longer becomes a viable possibility.
The good news is that those that stay the course with their retirement savings are likely to earn investment returns that at least match inflation, and even have a good probability of outpacing it. As we’ll learn below, history is on the side of the long-term saver when it comes to inflation-adjusted investment returns.
As long-term investors – especially if you’re investing for retirement many decades from now – your best bet is to keep investing on a periodic schedule. Markets are prone to fluctuate, and economic shocks are surprisingly quite common; the one thing over which you’ll always have control is your own behavior. That’s why it’s so critical to not get deterred and to continue adding to your nest egg at every opportunity.
While inflation does eat away at your spending power – meaning your dollars will buy fewer and fewer goods and services – it turns out that not investing will worsen inflationary effects. In other words, even if inflation were to persist at 8%, you’d be far better off investing to earn between 6 and 10% rather than leaving money in a savings account to earn less than 1 percent.
As a reminder, the long-term annual return of the S&P 500 is just over 10%, while the long-term inflation rate in our economy has historically been about 3.5%. This means that continuing to invest over long periods (through wars, pandemics, and other global calamities) has shown itself to outpace inflation by fairly healthy margins. Of course, we have no way of knowing if the future will mirror the past, but we do have a sizable body (over a century’s worth) of evidence on which to rely.
From a policy standpoint, the Federal Reserve will seek to raise interest rates in response to burgeoning inflation. The goal is to slow down the economy by increasing the cost of credit. In the homebuying realm, persistently low interest rates have sent housing prices through the roof over the past two years. With rates increased and set to increase further, buyers might tend to think twice about borrowing money to up their bid on a house when their cost of borrowing is higher.
From the perspective of the average saver, the choices are somewhat limited, though the prudent behavior is to simply continue investing in low-cost, broad-market index funds (likely available in your 401(k) plan) and maintain your focus towards the future. For money earmarked for shorter time horizons – that is, non-retirement money – traditional savings accounts are sufficient (with the understanding that the money is to be spent, not held for the long term).
For the past several months, the once-forgotten I-bond has come back into vogue. Series I bonds, which are only available for purchase directly from the government via the TreasuryDirect website, allow investors to take advantage of higher inflation rates.
I bonds pay a rate of interest equal to a fixed interest rate plus a semi-annual inflation rate. For bonds issued between November 2021 and April 2022, the guaranteed rate of interest is 7.12%. Since traditional bank savings accounts pay less than 1% annually, I bonds present an interesting method to stash away a portion of savings.
Purchases are limited to $10,000 annually (that’s per individual, not per couple). It’s also good to know that the interest rate for I-bonds adjusts every six months, which means your rate of interest will periodically change. It’s impossible to know how rates (both interest and inflation) will change in the future, but the rates are relatively attractive at the moment, which makes the bonds worth looking at.