Should I Worry About Inflation?

Dear Carrie,

I keep hearing about the threat of inflation and am starting to feel it when I open up my wallet. Should I be concerned?

—A Reader

Dear Reader,

Great question and you’re not alone. Lately, I’m hearing from lots of readers concerned about sharp increases in the cost of big-ticket items like housing and cars to everyday purchases like gas and groceries.

Much of the concern about rising prices depends on your age and circumstances. Many older investors recall the double-digit inflation and gas lines of the 70’s and are understandably worried about the ability of their savings to keep pace over time. The sentiment may be very different for young people who have only known low inflation. Unless they're competing for a house or shopping for a car, inflation may not seem like such a big deal.

Whether current inflation bursts are an anomaly or a sneak peek into what lies ahead is a bit of a guessing game, even for economists. Only time will tell, but many experts believe that the Federal Reserve and prudent government policy will prevent an extended period of high inflation. Bottom line, we need to be positioned to weather whatever happens. 

Inflation is mostly about supply and demand

To a large extent, inflation is about supply and demand—a lot of money chasing limited goods and services pushes prices up. As our economy recovers from the pandemic, we have record savings combined with pent-up demand for everything from home improvement projects to cars to travel. All of those weddings and celebrations that were postponed? For now, people seem to be willing to pay more for everything they missed. It’s a welcome bonanza for the hotels, airlines, caterers and florists who suffered for a year and a half.

But how will rising inflation affect you? The answer largely depends on what you’re spending your money on and what alternative choices you have available. While older people may be more vulnerable to increases in health care costs, inflation can also be hard for younger people who may be raising children and paying for childcare or college. It’s one thing to decide to postpone a vacation and an entirely different situation if you’re buying groceries or paying a medical bill. That’s a lot of the reason inflation isn't consistent across the board. 

Inflation compounds over time

It may be easy to dismiss a few percentage points of price increases (the Fed considers about 2 percent inflation to be the sweet spot to keep the economy ticking but not overheat), but the truth is that even small amounts of inflation can seriously erode your net worth and purchasing power over time. Not to be macabre, but that’s why some people refer to inflation as “the silent killer."

As an example, a 3 percent rate of inflation will cut your purchasing power by 26 percent after 10 years and 45 percent after 20 years. Retiring with $1 million dollars may sound fine today, but if we have a relatively modest but consistent inflation rate of 3 percent a year, that $1 million will have the purchasing power of about $560,000 in twenty years—and less if inflation is higher. This is precisely the reason we need our investments to outpace inflation.

Five steps to help counter inflation 

It’s great to understand how inflation works, but even more important to take appropriate action. Here are five ways you can protect yourself against higher inflation.

1. Stay invested—and diversified. Probably your strongest defense against long-term inflation is maintaining a globally diversified portfolio. Over long periods of time stocks have historically outpaced inflation, and fixed income funds (including money market and bond funds) will generally reinvest in newer holdings that may have higher yields. As part of a diversified portfolio you can also consider incorporating Treasury Inflation-Protected Securities (TIPS), Series I Savings Bonds and other asset classes into your portfolio to hedge against higher inflation. But whatever you do, don’t attempt to "time" the market by jumping in and out as the markets shift. History suggests that the best course is to stay invested over time. You can also consider dollar-cost averaging to gradually increase your holdings.

2. Pay off variable debt—or at least move to fixed rates. As inflation rises, so do variable interest rates. It’s never a good idea to carry expensive consumer debt (which is often variable), but as interest rates rise, you’ll pay even more. If you believe inflation is picking up, look into refinancing any adjustable-rate loans (for example, your mortgage) to a fixed rate.

3. Prepay, buy in bulk or substitute. As prices rise, consider prepaying for big-ticket items. This could include an appliance you know you’ll need to replace or even college tuition. Ask yourself if there are cheaper alternatives when buying a good or service.

4. Build inflation into your financial plan. One of the best tools for combatting inflation is to consider how it can affect your financial plan. That way, you're much more likely to meet your future goals—from college to retirement. People who are in retirement and rely on a fixed income are often the hardest hit by inflation, so it’s especially important to be flexible with your spending based on changing market and inflation conditions. Run different scenarios with a range of projections and don't forget to include health care. 

5. Keep fees to a minimum. Finally, don’t overlook the insidious way high fees can eat into your investment dollars. This is true no matter what inflation does, but especially important when inflation is already taking its bite.

Expecting the unexpected

When we financial planners talk about ‘expecting the unexpected’ we’re usually referring to things like insurance and emergency savings—and those are essential. But anticipating and being prepared for inflation—in your spending, saving, investing, college planning and retirement planning is equally important. You can’t control the economy, but you can be smart about how you control your own money. Therefore, my response to your question is not to worry, but to remain aware—and prepared.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.