Sitting down at the fire with Grandpa over spring break, people gear up for a trip down memory lane and are sure to hear tales of when a movie and popcorn only cost a nickel. While the anecdotes get laborious, this illustrates the core principal of finance: a dollar today will not be worth the same as a dollar tomorrow. Financial analysts and planners work every day to ensure that financial goals are met and that customer’s capital gains or at the very least maintain value as a result.
One key factor to consider when creating a plan for the fiscal future is inflation. Inflation is a measure of the general rise in price levels for goods and services in an economy. The value of everyday items depends on the value of currencies. For this reason, central banks around the world attempt to control severe inflation or deflation in an effort to keep the costs of goods for consumers relatively stable. The inflation rate in the U.S. has averaged 3.34 percent in the past 100 years. The latest release of current inflation level data from the Bureau of Labor and Statistics (BLS) measured 1.6 percent. To measure inflation the BLS uses a “basket of goods,” which takes a weighted average of goods consumers use on a daily basis. The basket from the current year is then divided by the base year and multiplied by 100 to derive a figure known as the Consumer Price Index (CPI). The CPI from the current period is then measured against the level from a prior period to arrive at the rate of inflation.
The Federal Reserve has loosened monetary policy and pumped money into the economy since the 2008 crisis. The Federal Reserve instituted its most recent easy money policy in the fall of 2013. Quantitative Easing 4 (QE4) is the process enacted by Federal Reserve chair Ben Bernake in 2013 to buy $85 billion in treasury and mortgage-back securities. The process not only puts money into the economy but also takes the securities off the market raising the ratio of demand to supply and keeping interest rates low. The theory behind this is that with low interest rates, investors will be more inclined to put their money into equities and products because there is less incentive to keep it tied up in bonds. One of the perceived drawbacks to this strategy is high inflation when the economy returns to normal. In an effort to control this, the Fed has also kept a tight fiscal policy. Fiscal policy deals with tax rates and government spending, and by keeping tax rates high and spending low, inflation can be controlled. Conceptually this makes sense, as higher taxes means less money in the consumers’ pockets and lower government spending means less job creation and less room for suppliers to raise prices.
With inflation rates 1.74 percent lower than the 100-year average, investors have to hedge portfolios in an effort to protect capital in the event of rapid inflation. TIPS are fixed-income securities that are indexed to inflation to protect investors from the negative effects. TIPS are backed by the federal government and the par value of the bond rises with inflation. While these securities may provide a safe haven for your fixed income investments, an equity portfolio will likely have a greater subsequent fall in value in the event of a renewed high-inflation environment. When currency falls in value, investors tend to flock toward hard assets that keep value in all environments, such as gold and natural gas. Increased demand when inflation is high coupled with the historically cheap price of hard assets may offer very good buying opportunities for investors looking to diversify their portfolios.
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