-Eleanor Blayney, CFP®, CFP Board's Consumer Advocate
It's June, the beginning of summer and hot weather. We can only wish our economy would heat up as well, which would be good for employment rates and our federal debt burden. However, as many of us remember from Econ 101, there can be a trade-off between full employment and stable prices. With increasing economic activity, we usually expect our consumer price index � the common measure of inflation � to go up as well. But what exactly is inflation, and is it always a bad thing? According to the noted economist Milton Friedman, inflation can be defined as "too much money chasing too few goods." When I was once asked to explain inflation to a fifth-grade class, I chose Friedman's simple definition as one that ten-year olds could understand. I gave each student $100 in ten-dollar bills, and then held a mock auction for a car. After a few preliminary bids, the price of the car quickly went to $100. I then handed out $1000 to each student, and held the auction again. No surprise when the car now sold for $1000. "What's happened here?" I asked the kids. Though they did not identify it as inflation, they did get the idea that more money in the system can result in higher prices. In my simple exercise, the impact of inflation was benign � it did not matter if the car cost $100 or $1000 or even $1 million, as long as everyone in my classroom economy shared equally in the increased money supply. But the real world is not so egalitarian. In an inflationary environment, there are winners and losers. Those more likely to win are wage earners (particularly those who receive cost-of-living increases), holders of foreign currency from countries with stable prices, and owners of commodities or real or tangible assets. Another winner is the government. Because interest rates usually rise with inflation, the outstanding federal deficit that was issued at lower, pre-inflationary interest rates costs less for the government to pay. The biggest losers are, of course, those who live on fixed income, such as retirees who rely on corporate pensions, non-indexed annuities, or portfolios of long term bonds. Furthermore, because rising prices do not impact the costs of goods and services uniformly, some individuals are more adversely impacted than others depending on their consumption mix. For example, the recent health care legislation has us all quite aware of the cost increases in medicine that have been trending well above the overall consumer price index. The same has held true for energy costs, particularly for oil. Those with chronic health problems who do a lot of travel may be scratching their heads when they hear that inflation is not currently a problem in the U.S. There are many who believe a bigger current threat than inflation is "deflation" � a condition where prices start falling. Yes, everyone likes a bargain, but not the economic conditions that bring these falling prices about. High unemployment can cause former wage earners to consume less, causing industry to cut production and to lower prices to rekindle demand. A deflationary spiral can be set up when consumers start expecting continued price declines, and therefore postpone their purchases until a later time when prices might be even lower. The example of Japan in the 1990s illustrates a deflationary cycle where saving rates were extremely high and the economy was at a standstill. At the moment, many in this country consider themselves stuck between a rock and a hard place when it comes to inflation and deflation. Both seem like plausible scenarios for our economy. The massive federal stimulus and injection of money into the economy sends up inflationary red flags. At the same time, stubborn high unemployment, foreclosures on mortgages, and the continued decline in home prices spell deflation. For investors � those, in other words, who have a choice as to what to do with their money � the conundrum is especially troubling. Buy inflation-indexed securities and commodities, or invest in long-term Treasuries? Sell your current home and downsize, or grab a mansion, perhaps in Greece, at a rock-bottom price? The questions change depending on that evening's CNBC report, but the answer stays pretty much the same. Diversification � or building a portfolio or even a lifestyle � that anticipates either scenario makes the most sense. Investing in both short and longer term fixed income, holding domestic as well as foreign securities, and making some discretionary expenditures now and putting some money aside for future consumption, is a winning strategy that any successful sport coach would endorse. You need both a strong offense as well as a good defense, whatever the game.
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It's June, the beginning of summer and hot weather. We can only wish our economy would heat up as well, which would be good for employment rates and our federal debt burden. However, as many of us remember from Econ 101, there can be a trade-off between full employment and stable prices. With increasing economic activity, we usually expect our consumer price index � the common measure of inflation � to go up as well. But what exactly is inflation, and is it always a bad thing? According to the noted economist Milton Friedman, inflation can be defined as "too much money chasing too few goods." When I was once asked to explain inflation to a fifth-grade class, I chose Friedman's simple definition as one that ten-year olds could understand. I gave each student $100 in ten-dollar bills, and then held a mock auction for a car. After a few preliminary bids, the price of the car quickly went to $100. I then handed out $1000 to each student, and held the auction again. No surprise when the car now sold for $1000. "What's happened here?" I asked the kids. Though they did not identify it as inflation, they did get the idea that more money in the system can result in higher prices. In my simple exercise, the impact of inflation was benign � it did not matter if the car cost $100 or $1000 or even $1 million, as long as everyone in my classroom economy shared equally in the increased money supply. But the real world is not so egalitarian. In an inflationary environment, there are winners and losers. Those more likely to win are wage earners (particularly those who receive cost-of-living increases), holders of foreign currency from countries with stable prices, and owners of commodities or real or tangible assets. Another winner is the government. Because interest rates usually rise with inflation, the outstanding federal deficit that was issued at lower, pre-inflationary interest rates costs less for the government to pay. The biggest losers are, of course, those who live on fixed income, such as retirees who rely on corporate pensions, non-indexed annuities, or portfolios of long term bonds. Furthermore, because rising prices do not impact the costs of goods and services uniformly, some individuals are more adversely impacted than others depending on their consumption mix. For example, the recent health care legislation has us all quite aware of the cost increases in medicine that have been trending well above the overall consumer price index. The same has held true for energy costs, particularly for oil. Those with chronic health problems who do a lot of travel may be scratching their heads when they hear that inflation is not currently a problem in the U.S. There are many who believe a bigger current threat than inflation is "deflation" � a condition where prices start falling. Yes, everyone likes a bargain, but not the economic conditions that bring these falling prices about. High unemployment can cause former wage earners to consume less, causing industry to cut production and to lower prices to rekindle demand. A deflationary spiral can be set up when consumers start expecting continued price declines, and therefore postpone their purchases until a later time when prices might be even lower. The example of Japan in the 1990s illustrates a deflationary cycle where saving rates were extremely high and the economy was at a standstill. At the moment, many in this country consider themselves stuck between a rock and a hard place when it comes to inflation and deflation. Both seem like plausible scenarios for our economy. The massive federal stimulus and injection of money into the economy sends up inflationary red flags. At the same time, stubborn high unemployment, foreclosures on mortgages, and the continued decline in home prices spell deflation. For investors � those, in other words, who have a choice as to what to do with their money � the conundrum is especially troubling. Buy inflation-indexed securities and commodities, or invest in long-term Treasuries? Sell your current home and downsize, or grab a mansion, perhaps in Greece, at a rock-bottom price? The questions change depending on that evening's CNBC report, but the answer stays pretty much the same. Diversification � or building a portfolio or even a lifestyle � that anticipates either scenario makes the most sense. Investing in both short and longer term fixed income, holding domestic as well as foreign securities, and making some discretionary expenditures now and putting some money aside for future consumption, is a winning strategy that any successful sport coach would endorse. You need both a strong offense as well as a good defense, whatever the game.
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