Inflation is going nuts — it’s now running at 8 percent annually, the highest rate recorded in 40 years. The risk that inflation will stay high or go even higher is real. The chance of inflation rising more than expected in the short term is, ironically, actually increased by the Federal Reserve Chairman, Jerome Powell’s, ongoing pledge to limit long-term price increases to roughly 2 percent. Whatever the factors driving inflation, virtually everyone needs to take financial cover. In what follows, I offer my 10 top Money Magic tricks for keeping inflation from ruining your finances.
Forget what Fed Chair, Jerome Powell, and other hopeful, if not simply wishful inflation thinkers are saying. Forget that the market thinks inflation will slow dramatically almost overnight. Realize that inflation is now running at 8 percent per year — the highest rate recorded in 40 years! Realize that inflation has worsened, month by month, since last January when its annual increase was just 1.4 percent. Realize that inflation is widespread — last month more than half of American products saw price increases, measured at an annual rate, above 5 percent. Realize that prices of the things we buy — the consumer price index (CPI) — reflect the cost of inputs — the producer price index (PPI), albeit with a lag. And the PPI rose by 9.7 percent over the past year, meaning underlying inflation is likely even higher than we think. And, most importantly, realize that we now have not just major inflation, but major inflation risk. Hence, whatever inflation is likely to be, we all need to take cover against what it might actually be.
Why is inflation on a tear?
Lots of reasons. Supply-chain bottlenecks, less competition thanks to COVID-related business failures, the rising cost of energy, a labor shortage due to and a government that makes money by making money, i.e. by printing it. Given Uncle Sam’s long-term insolvency — our government’s deplorable, bi-partisan, postwar achievement, the prospect for far higher inflation abounds. Chairman Powell can proclaim inflation expectations to his heart’s content. But he can’t control the prices set by our nation’s roughly 8 million businesses. If they believe that inflation is on the rise and that they need to protect against greater than expected inflation when they periodically raise prices, well inflation can head off to the races.
Would that everyone’s wages, profits, assets, debts, taxes, and benefits adjusted immediately to prevailing inflation. Then our real (inflation-adjusted) economy would be inflation-proof. That’s hardly the case. Indeed, if you read the predicted path of future inflation from the difference in yields on nominal and real (inflation-protected) Treasury bills and bonds, the market believes Chairman Powell’s view that inflation is very short term. But there’s some economic irony here. To the extent the Fed can credibly lower long-term inflation, it will likely exacerbate current inflation.
The reason is the Fiscal Theory of the Price level, discussed in Stanford economist John Cochran’s terrific new book by that title. John makes clear that since our fiscal system is not fully inflation-indexed, inflation, even when expected, raises the government’s real revenues. Hence, as the Fed controls long-term inflation, it worsen the government’s long-term fiscal condition. Absent congress responding by raising taxes or cutting spending over time, there is just one release value — current prices rise to help restore fiscal solvency by reducing the real value of the government’s outstanding nominal debt. (The immediate price increase reflects households spending more in response to a lower perceived future fiscal burden.) Hence, the less worried we are about future inflation, the more worried we should be about current inflation.
How much should we worry about inflation. In many cases, a ton!
Say you’re a middle-aged, middle-class couple with $100,000 in a money market fund. Last year’s inflation cost you $7,500 in purchasing power. Your burning question is how to prevent losing another $7,500 this year? Here are ten answers.
1. Buy up to $10,000 in Treasury I-bonds for each member of your household. I-Bond interest rates are set by the government and generally exceeds the market return. They earn a fixed return (currently zero) plus a return set bi-annually based on inflation. The inflation-based rate is 7.22 percent through April. You can, but don’t have to hold an I-bond for 30 years. You pay no federal taxes on accrued interest until the bond is cashed out. Furthermore, the payout is exempt from state and local taxes. Best yet, if you use redemption proceeds to pay for qualified higher education expenses, you’ll face no tax whatsoever!
2. Buy TIPS — Treasury Inflation Protected Securities. Principal and coupon payments are adjusted monthly for inflation. Today you can invest in 30-year TIPS and earn negative 14 basis-point (minus 14 percent of one percent) annual real return. This means $1,000 invested today will deliver $959 in purchasing power after 30 years. That’s rather awful. But if you’ve maxed out on I-bonds and simply want to preserve your real principal, long-term TIPS is one way to go. This said, the inflation component to the return to TIPS is subject to taxation. With high enough inflation, a “safe” TIPS investment could mean paying much higher than expected taxes to Uncle Sam.
3. Borrow money on your house and use the proceeds to buy TIPS of equal maturity. The FHA mortgage rate is now 4.23 percent. Suppose you borrow $300K for 30 years, use the proceeds to buy TIPS, and inflation is unexpectedly high, averaging 6 percent. Your TIPS coupon and principal payouts will adjust annually for inflation. So their return will be insulated. But you’ll get to pay off your mortgage in watered-down dollars. On balance, you’ll end up ahead by over $60K in present value.
4. Buy real assets whose values will keep even with inflation. This can be homes, home improvements, land, rental real estate, cars, furniture, art, jewelry, gold and other precious metals, REITS (real estate investment trusts), and yes a bit of Bitcoin.
5. Hedge higher future inflation by buying securities, like IVOL, that make money when the yield curve tilts upward — something that higher future inflation would cause. In general, there are put options available that make money if interest rates of particular maturities rise. Hence, if you think that inflation could be higher than expected in the long term and would put you at severe risk, you can buy securities that are engineered to do well when interest rates rise.
6. Buy stocks of companies, like Microsoft
MSFT
, that can easily adjust their prices in light of inflation. In Microsoft’s case, they are selling licenses whose prices can be adjusted instantaneously.
7. Spend more time doing comparison shopping. When inflation is high, prices for the same products generally become more diffuse. Online services, like MoneyWise, can search for better deals, including finding you discount coupons.
8. Consider buying Canadian long-term inflation-indexed bonds. These bonds yield roughly 1 percent real. That’s over 100 basis points more than comparable U.S. TIPS are yielding. Moreover, the Canadian dollar is historically rather low. And Canada doesn’t face our crippling long-term fiscal problems. This said, not every broker deals in Canadian bonds and you may need to take the foreign tax credit to cover Canadian taxes on your Canadian bond return.
9. Invest in commodities, including oil and gas companies, grains, and metals. They are time-honored inflation hedges.
10. Invest in yourself. As I’ve written, I generally hate student loans. But the undergraduate federal student loan rate is now 3.73 percent. If inflation remains high, you’ll end up paying a very high negative real return. In other words, Uncle Sam will end up heavily subsidizing your education.
Inflation has been remarkably low in recent decades. Hence, the track records of assets that hedge inflation will look worse as a result. The same is true of the return on your homeowners policy. If you’ve had no losses, the policy hasn’t paid off. But that’s the good news, because insurance policies pay off in bad, not good times. If an insurance policy doesn’t pay off, it means you’ve been spared a loss. Similarly, assets that hedge inflation are valuable not because of their average performance, but because they perform well when inflation is unusually high. And if you are significantly exposed to inflation, buying inflation insurance in one or more of the above-listed ways is well worth considering.