Wednesday, October 27, 2021

How inflation works and why you need to be concerned

Ever wonder how inflation works? This week my colleague Martin Teicher and I will explore the impact of inflation on the investor. You can click here to hear from me on why inflation continues to rise and why that’s not so great for the investor.

If you remember a few months ago, the Fed raised interest rates by 0.25 percent, much to the surprise of many economists. While this may not sound like much, it is significant if you think about it for one fundamental reason: it is a three-and-a-half-year rate of increase, so there was a 10 percent increase at the rate at which the Fed raises interest rates (that’s a five percent rise a year) if we sit here at a quarter of a year. That’s 40 percent of the entire rate increase that has happened over a three-and-a-half-year period.

Historically, one might argue that increased inflation — however slight — tends to flatten the yield curve. Let’s take a look. When a person is growing their savings — their money — they move their money out of U.S. Treasuries, a security that pays the government a fixed rate of interest, and into T-bills, a safe, short-term asset paying a fixed rate of interest. In theory, you have the opportunity to make more with your money in T-bills than you do with your savings at the Fed. Your long-term savings would likely be higher in return for this switch.

But there is the problem. If inflation is higher than the interest rates that the Fed is charging — or if people grow worried about higher inflation and stay away from cash — then the long-term value of what you own in T-bills declines. Inflation works to flatten and devalue the value of cash — your savings — when investors grow concerned about inflation and start pulling money out of the bond market. When you say “normal” inflation is 2.5 to 3 percent, you are actually equating a CPI of 3 percent to 3.5 percent to your value of cash in the bank. This may sound OK for you in the short term, but if you want your money to last in your bank account for the long-term, the longer you sit on your money, the worse off you are going to be. In a nutshell, the central bank created the problem by raising interest rates faster than inflation was coming into the market.

Now to be fair, the vast majority of inflation right now is not the result of a central bank raising interest rates. Instead, it is the result of the energy prices rising dramatically in the U.S. and worldwide. But while the Fed and many economists believe that inflation is hitting very low levels today, you should understand that in the long-term, inflation can be a pain. It is not as easy to hedge against as a rising interest rate environment.

Martin Teicher is a research analyst at the Tax Foundation and a registered investment adviser. He is a commentator and has served on several national media outlets since the 1990s, including CNBC. His previous columns are available at http://www.taxfoundation.org/blogs/blog-considered-top-commentary-in-house/Martin_Teicher_State_of_the_Taxes/

A version of this piece appeared in The Federalist on May 14, 2016.

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