Pros and Cons of Higher Inflation

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Inflation is bad, making things more expensive.  Except that it can also be good, when it brings you a raise or makes it easier to pay your debts.

So which is it? The chief economist at the International Monetary Fund argues in a recent paper that, well, maybe the Federal Reserve should aim to keep inflation at 4% instead of 2%, the current target.

Olivier Blanchard argues that a 2% target is so low it leaves central bankers with little room to cut further, the key strategy for perking up an economy in the doldrums.

Higher inflation can be useful for governments, individuals and businesses that carry lots of long-term debt. When inflation raises your income, your mortgage payment gets easier to handle, for example.

But if you had a pension with no cost of living adjustment, higher inflation would eat more deeply at your buying power. Also, higher inflation is generally accompanied by higher interest rates. So retirees dependent on bond income would have to scramble.

Older bonds paying lower rates would become less marketable and would lose value. Investors might be forced to sell them at a loss to free up money to invest in the newer, more generous bonds. Of course, they could hold their bonds to maturity, but then they’d be stuck with low yields as prices rose faster with inflation.

Raising the inflation rate by 2 percentage points seems modest at first glance but could be devastating to a fixed-income retiree over 20 or 30 years. Imagine a 45-year-old investor with a $250,000 nest egg, able to save another $12,000 a year until retiring at 65. With inflation at 2% and an investment return of 8% before retirement and 6% afterward, the investor could expect his holdings to provide nearly $7,000 a month in today‘s dollars. Double inflation to 4% and that falls to $4,700. Use the Retirement Income Calculator to try your own numbers.

What can the investor do to compensate? Traditionally, stocks are seen as one of the best inflation hedges. In the 20th Century, stocks returned an average of about 10% a year, or 7% after inflation, which averaged around 3%. Bonds returned around 5% before inflation, only 2% after. Cash generally earns nothing once inflation is taken into account.

This is why financial advisors recommend that young investors make a heavy allocation to stocks. Even retirees are often told to keep at least 30% of their holdings in stocks, so their nest eggs don’t shrink too fast in after-inflation terms.

Stocks are not immune to inflation. Higher labor and materials costs can undermine corporate profits, driving stock prices down. But over time, companies are generally able to offset that by raising prices for goods and services they sell. An ordinary bond has no way to compensate for rising prices. It simply produces a steady income stream with a yield, or interest rate, which does not change.

There is an exception: Treasury Inflation-Indexed Securities, government-issued bonds that do adjust to inflation. Every six months, the government adds some money to the bond’s principal to reflect inflation. The bond’s yield remains fixed but is applied against the ever-growing principal to produce payments guaranteed to grow enough to offset inflation. TIPS can be purchased directly from the government. Also, most mutual fund companies offer funds holding TIPS.

 

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