After an economic downturn, it’s not uncommon to see a mismatch of supply and demand as battered sectors of the economy ramp up their operations and rehire workers. That’s why prices of highly sought-after goods and services tend to spike, at least in the short term, as buyers and sellers move towards a more balanced level of capacity.
What’s more important is to ascertain whether increasing prices are likely to persist over a longer period, which might prompt government intervention to bring things back under control again. Where businesses are simply selling their product for a higher price because they can (for higher profits), competition will rein in the effects of rising prices naturally.
However, when businesses are simply passing on higher costs of their own, and in particular ones that aren’t likely to decline to prior levels (such as wages), this can be a sign of more persistent inflation, which the government will have to deal with at some point.
So here we’ll walk through why inflation is a bit of a goldilocks situation in that getting just the right amount of inflation is key in order for most people to benefit from its effects.
The good
In an ideal scenario with modest, steady inflation (let’s say 2% per year) most people would see their sources of income rise by a similar amount (such as salary). When it comes to how people use their income, not all priorities would see the same impact.
Most living expenses would track inflation (as would taxes upon rising incomes), while other expenses such as debt (mortgage, auto, student loans) would remain fixed. That’s why when incomes rise, but only some expenses do, the difference creates additional savings or disposable income.
The bad
When inflation becomes high or unpredictable, the opposite tends to be true in that household income and living expenses do not necessarily move in tandem. As an example, let’s say that incomes rose 2% but living expenses increased by 5%, and existing debt payments remained unchanged.
That’s why when incomes rise by a smaller amount than expenses, household savings capacity can quickly evaporate. In more severe cases, this could ultimately lead to difficulty in meeting loan obligations, which can lead to big problems with lasting consequences (i.e. credit score).
The ugly
In situations where inflation reaches levels that are too high as well as persistent, this necessitates government intervention. The cure for an overheating economy is raising interest rates, and this tends to be unpleasant because it results in lower economic activity. Higher interest rates means that payments on newly created loans will rise, and making fewer financial transactions economically feasible.
In this blog, I discussed how the US Government reduced interest rates by 1.5% due to Covid, using the example of how the monthly payment for a $1M mortgage with a 4.5% interest rate was equal to a $1.2M mortgage with a 3.0% interest rate. Mortgage payments, and thus the budget of all homebuyers, are highly sensitive to changes in interest rates. However, if interest rates rose meaningfully, we’d be considering a similar move in the opposite direction.
Tying it all together
That’s why when it comes to managing your money, it takes a thoughtful approach to making sure that your money can both benefit and be protected from varying levels of inflation. This means finding the right balance between saving, paying down debt, and investing in the right assets.
If you’d like to discuss how to optimize your money to handle a changing economic landscape, let’s talk.
This blog was written by Jeremy Bohne, Principal & Founder of Paceline Wealth Management. Paceline is a fee-only investment advisor serving clients in the Boston area, and on a remote basis throughout the country. Paceline specializes in helping tech and biotech executives, physicians, and those seeking financial planning services.