Perhaps the single greatest question facing investors now is, “What will happen to inflation?” This was recently highlighted with the news of a grounded freighter that is blocking the Suez Canal, cutting off shipping between Asia, Europe, and the U.S. This brief disruption to global trade stoked fears of increasing prices and the long-dormant menace of inflation among the public, but investors have been watching out for inflation for some time now.
Inflation and interest rates
Inflation is one of the single most important factors affecting interest rates. Interest rates, in turn affect just about everything else. This is because the people who lend money are most concerned with getting their money back AND how much their money will be worth in the future when they do get it back. This second component is all about inflation and the purchasing power of your dollars in the future.
Changes in inflation and interest rates are notoriously hard to predict. Indeed, few forecasters can predict any market and economic changes consistently or accurately. For instance, there has been widespread fear since 2009 that federal government deficits and the Federal Reserve’s low interest rates were certain to result in hyperinflation, which clearly has not happened. With that caveat, here is my best stab at explaining why it’s important and what may happen with inflation.
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Will inflation increase in 2021?
There is a strong case to be made that inflation will likely be somewhat higher in the coming months. This is because it is measured as the year-over-year change in the cost of things, and the price of oil is a big part of that calculation. A year ago, a barrel of oil cost about $30. You read that right. In March 2020, sellers of oil had to pay people to take it off their hands because the global economy was in free fall and there was too much oil available.
Today, oil is selling for about $60 per barrel. That alone will mean a large change in the measurement of inflation. Construction costs have also risen due to material shortages and global supply chains are still reeling from the combined effects of the global pandemic and U.S. trade spat with China. So there will be higher inflation this year. The question for investors, then, is whether inflation remains higher or drops back down to around the 2% level where it has been for the past decade or so.
The biggest driver of inflation
How much inflation we see will largely depend on the labor market. Sustained inflation can only happen if people have the money to pay the higher prices. That requires steady jobs and, more importantly, the ability of workers to demand higher pay. In theory, low unemployment should lead to higher inflation, but that hasn’t been the case since at least the 70s. Even with record low unemployment in 2019, there was little evidence of upward pressure on wages, particularly among the lowest income workers.
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Over the past few decades, globalization has also helped to bring down prices as manufacturing moved from high cost developed countries to lower cost locations like China and Bangladesh. As labor costs rise in those places, there are still other locations for labor-intensive production to go to keep costs down.
One factor that may begin to reverse this trend is a push to bring production back to the U.S. The shortage of masks and gowns early in the pandemic and the more recent shortage of computer microchips for automobiles highlighted the hollowing out of U.S. manufacturing capacity. An effort to bring this production capacity back to the United States may cause a gradual increase in prices, but this will take a long time to be felt by consumers.
The Federal Reserve has indicated it will keep interest rates low until they see signs of full employment AND rising prices. That means that short-term interest rates (like those on savings accounts and money market mutual funds) should be low for some time. Longer-term interest rates have been rising, signaling investors are expecting higher inflation. However, nothing indicates expectations of runaway inflation or even much higher than 2% or so we’re used to over the next few years.
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We will likely see higher prices this year as the pandemic eases and supply chains sort themselves out. Without significant gains in wages, however, significant inflation shouldn’t be a problem.
Inflation is just one of the many factors that can affect your retirement. At Blankinship & Foster, we help you build a sound financial plan and a long-term investment plan to match it. With a long-term focus and a well-thought-out plan for achieving your goals, you can look to the future with confidence.
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