Inflationary Fears
Growing up, we never discussed the stock market. It just wasn’t part of my household, my neighborhood, or (to my recollection) the national zeitgeist.
My parents probably had some money tucked away in a mutual fund or two that were recommended by my Uncle. The Sunday newspaper had a thick section filled with the weekly summary of stock and mutual fund trading values printed in impossibly small print. The subject was a foreign language, full of arcane symbols.
The only investments ever discussed were savings accounts and certificates of deposits. I would take my birthday money to the bank along with my savings passbook. The clerk would fill out the deposit slip and enter the deposit amount in the passbook, initialing the entry.
Growing up with inflation
The bank paid 5% on deposits. We never shopped around for a better rate, because it would have been too inconvenient to travel elsewhere to transact business. During my high school years, inflation grew to 5%, then 7%, then 10%, finally reaching a peak of 13.5% in 1980. As I recall, the bank continued to pay about 5% on my savings. Even with my measly high school math I knew I was losing ground. Inflation was the story of the day. It dominated the nightly news. President Ford encouraged the nation to “Whip Inflation Now,” with his big red WIN buttons.
I don’t mean to bore you with tales from this old geezer’s childhood. I’m telling you this in case you are too young to have lived through inflationary times.
The graph below shows the relative changes in the Consumer Price Index (CPI) and the S&P 500 index over my lifetime (so far). Both values are normalized to 1. If someone had bought stock in the year I was born, and held it through my college graduation, they would have lost money, relative to inflation. No wonder no one talked about the markets!
Since 1980 we have had very steady* but slow, controlled inflation, at an average annual rate of about 2.3%. Some conspiracy theorists believe that the government has been cooking the books to keep the inflation calculation artificially low, so it doesn’t have to give senior citizens a Social Security cost-of-living raise. But when I think back to the cost of common items like a candy bar or milk I think it’s probably actually increased by a factor of 2 since the 80’s, which is what the chart says, so I don’t think the government has been cheating.
Note also that since 1980, or maybe a bit before, the S&P 500 has been on a tear, increasing at an average annual rate of about 8.8% (ignoring the internet bubble of 2000). That’s a real return of 6.5% (8.8% – 2.3%). That made saving (and investing) worthwhile.
Will inflation return?
Isn’t that the $64 question? Our government’s been printing money to pay for bailing out the banks and carmakers. It’s ok to print extra as long as the economy grows to absorb the cash infusion, but we’re not growing much right now. If we can’t absorb it, then we need folks to buy it in the form of T-Bills and the like.** Thankfully, China and others continue to support our excesses. However, we need to consider what would happen they stop buying. Or if the imbalance between printing and growth stays out of whack for very long.
How can I protect my investments, should inflation return?
There are a few things you can do now to help guard your nest egg against the ravages of inflation.
- Bonds. Check that your bonds and bond funds have a relatively short duration. That means that they’ll be more able to respond to interest rate changes. Interest rates received on deposits usually rise during inflationary times (despite my childhood experience). For example, you probably wouldn’t want to buy a 30-yr Treasury today. You’d be locked in to its 4.5% payout. Better to go for a shorter term note. It’ll pay a lower rate, but you can reinvest it sooner at what is likely to be a higher rate.
- TIPS. The principal of a Treasury Inflation Protected Securities rises with inflation. The rate is fixed, but since the principal rises, so does the semi-annual interest payment. When the security matures, you receive back the inflated principal. The minimum purchase is $100. A recent issue rate for a 10-year TIPS is 1.875% vs. 3.625% for a non-inflation-indexed Treasury note.
- I-bonds. A version of the venerable Savings Bonds, the return on I-Bonds is also pegged to inflation. You can buy these in denominations of $25, with a maximum purchase of $5,000 per year per person.
- Inflation “plays.” You could short long bonds. (That’s just fun to say.) Short sell an ETF that invests in long-term bonds, for example, Vanguard’s EDV. If inflation rises, the value of the long bonds will fall.
- Commodities. Inflation means that the price of basic stuff rises. Copper. Gold. Timber. Commodity ETF’s can take the edge off.
I hope inflation doesn’t return. The Fed has a 30-year (and counting) track record of matching the money supply to national growth. Perhaps we’ve actually learned to to manage it. This year was extraordinary, of course. The next few years should tell the real story.
*Note that the vertical axis on the graph uses a log scale. A straight line indicates a constant rate of change.
**This version of the Federal Monetary Policy has a bit of “poetic license.”
Disclaimers: This information is provided for educational purposes only. It may not apply to your personal financial situation. Before investing, you may want to discuss your plan with an investment advisor or financial planner. Investments in ETF’s and in mutual funds are not FDIC insured and can cause loss of principal. (You can lose money).
Full Disclosure: No position in EDV.
By day, Helen engineers new materials to make computer chips cheaper, better, and faster. When the son goes down (pun intended), she writes about personal finance at Affine Financial Services.
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