Inflation is Cooling but the Pain May Linger for A While

Good news! The latest data indicates that inflation is cooling. The bad news is that consumers should expect prices to stay high for a while.

After a year of surging prices not seen for four decades, inflation is finally starting to ease its grip on the U.S. economy. The Labor Department reported on May 10 that the consumer price index (CPI) rose 0.4% in April from the previous month, though it was still much higher than the 0.1% March increase. Annually, inflation climbed 4.9%, nearly half its 9.1% peak, but still more than double the Fed’s 2% target. It was the smallest increase in almost two years.

While that is welcome news for consumers, their financial pain from high prices will likely linger for a while. While the overall inflation rate is 4.9%, most food prices are still increasing at a double-digit rate. Even though commodity prices—i.e., corn, soybeans, rice, and barley—are flat or, in some cases, decreasing, it will take a while to impact groceries. As a result, the likelihood is that grocers may pause or slow food price increases but not lower them.

That’s because, regardless of whether inflation is surging at 9% or rising within a normal 2 to 3% range, inflation is always with us, which means prices are always increasing.

Wage Increases Will Keep Prices High

The stubbornness of high prices is exacerbated by rising wages which fuels demand, keeping upward pressure on prices. And as wages increase, employers are having to pay more to get people to come to work, causing them to increase prices to cover their higher costs. Because employers are not likely to reduce wages, those higher costs will persist indefinitely, impacting all business sectors. That’s why we should expect restaurant and hotel prices to remain elevated. 

What Can Cause Prices to Decline? 

If higher inflation persists for too long, wages will likely not keep up, causing demand to go down and increasing the risk of a recession and deflation. If you thought inflation was scary, it’s nothing compared to deflation. Deflation can have a devastating effect on the economy. Once it starts, it’s difficult to stop because it is self-perpetuating. 

Typically, when demand decreases, it can lead to a correction in the supply-demand imbalance, which is good. But, if demand falls too far too quickly, it can cause a downward spike in supply, which can drive prices even lower. When consumers believe they can wait on their purchases because prices will be lower in the future, it can accelerate the decline of supply. When supply declines, businesses cut back on inventory and production, leading to lost jobs and wage deflation. Then consumer spending falls further, exacerbating declining demand and price reductions, forcing businesses to close and driving the economy further into a recession. 

While that scenario is not likely in the foreseeable future, it helps to understand that inflation is not the worst thing that could happen. Allowing mild inflation to persist reduces the risk of deflation. 

Even Mild Inflation Can Threaten Retirees’ Purchasing Power

Inflation has always been an issue in retirement planning because it can reduce purchasing power over time. Even mild inflation, say 3%, can cause a 50% loss in purchasing power over 23 years.*  In other words, it will cost you twice as much to maintain your current standard of living. Higher inflation can reduce it faster. For example, at 6% inflation, your purchasing power is reduced by half in 12 years. That means the amount of money spent today for two Thanksgiving turkeys would buy you just one in 12 years.

Conservative Planning Assumptions Can Keep Retirees Safe and on Track 

A well-conceived financial plan uses conservative assumptions to account for the worst economic scenarios, such as high inflation and periodic recessions. For example, rather than using historical stock market averages of 8% to 10% to project asset growth, you should apply a more modest projection, such as 5%. And while high inflation is not likely to persist forever, you want to assume an inflation rate higher than the average of 2.5% over the last 20 years.

Also, expanding longevity is a risk that compounds the risk of inflation. In planning your time horizon, you should also assume that you will outlive 75% of your peer group (past age 90), to provide a planning cushion against living longer than expected. With so much economic uncertainty, building in as much cushion as possible is essential to keep you safe and on track to meeting your retirement goals. 

*To calculate how long it will take to reduce your purchasing power by half at any inflation rate, just divide 72 by the inflation rate.


Resources:

https://www.bls.gov/cpi/

https://www.ers.usda.gov/data-products/food-price-outlook/

https://www.federalreserve.gov/monetarypolicy/inflation.htm

https://www.investopedia.com/articles/retirement/06/inflationretirement.asp

https://www.forbes.com/sites/forbesfinancecouncil/2017/09/19/inflation-and-its-impact-on-retirement-planning/

https://www.bea.gov/data/income-saving/personal-income

https://databank.worldbank.org/reports.aspx?source=global-economic-monitor-(gem)-commodities

https://www.cnbc.com/2021/06/10/us-inflation-what-to-know-about-the-economic-recovery.html