Making Ends Meet
Many market pundits are predicting that inflation will stabilize at a higher rate than the 2% Fed target. The rationale is that as inflation comes down, the Fed does not want to force inflation to 2% and risk a bad recession. As a result, Inflation is more likely to level off around 3%, and the Fed, in theory, will move the goalpost to a 3% inflation target and declare victory. That 1% change may not sound like much, but it has ramifications for everyone saving for retirement.
Inflation is generally discussed in terms of rising prices. Over the last few years, we’ve seen huge spikes in many commodities, lumber, eggs, etc. as examples of the effect of inflation. Now those prices have largely corrected, and inflation now appears to be less of a problem than it was a year ago.
An alternative way to look at inflation is as a decline in the value of the dollar. If prices double, the value of the dollar has been halved. If you are saving for retirement, you must account for the declining value of the dollar. We intuitively know that the faster the dollar declines in value, the more we need to save, but it is difficult to imagine what that really means. Here is a way to think about it.
Let’s start with the assumption that you plan to retire at age 65 and expect to live another 30 years. If inflation runs at 2% per year, the current Fed target, the value of the dollar declines by about 45% in 30 years. In general, what costs $100 when you are 65 years old, will cost about $181 by the time you reach age 95.
If you are 35 years old, your savings might have to withstand 2% inflation for 60 years. What that means is that from age 35 to 95, the value of the dollar declines by 70%. What costs $100 when you are 35 years old, costs about $328 by the time you hit age 95. Two percent inflation may not sound like much, but over time, it can certainly do some damage.
Now let’s do the same analysis assuming 3% inflation. At age 65, with a life expectancy of 95, 3% inflation reduces the value of the dollar about 60% in 30 years. In general, what costs $100 when you are 65 years old, will cost about $243 by the time you reach age 95.
If you are 35 years old, and are confronted with 3% for 60 years, that means that from age 35 to 95, the value of the dollar declines by 86%. What costs $100 when you are 35, costs about $589 by the time you reach age 95. Suddenly, 2% inflation doesn’t sound so bad!
The point is that many will make it sound like allowing inflation to run at 3% isn’t that different than 2% inflation. They couldn’t be more wrong. At 3% inflation, in 60 years, the value of the dollar is roughly half the value that it would be if inflation were 2%.
For portfolios, this means that we need to pay attention to the ability of equities to overcome inflation. Yes, stocks are volatile, and that is never pleasant, but, depending on individual circumstances, it could better to live with a little more volatility than have your nest egg slowly eaten away by inflation.
What? This isn’t on Your Calendar?
The Jackson Hole Economic Symposium is scheduled for Aug 24- 26 and is attended by everyone who is anyone in the world of economics; that is, central bankers, finance ministers, key investors and academics from around the globe. Typically, the highlight of the proceedings is the speech by the Fed Chair, this year on Aug 25, at 10 am, where the world expects an official update on the U.S. economy and the potential for policy changes, against a backdrop of economic trouble in China.
The 2023 Symposium comes at a particularly interesting time as a sudden rise in U.S. interest rates has strengthened the dollar, putting increasing pressure on emerging economies, including China, which is already dealing with well below trend growth and financial difficulties in the housing sector.
The rise in rates also creates issues back here in the U.S., as mortgage rates rise and financial conditions tighten overall. This summer, markets have been fully on board with a soft economic landing as a worst-case scenario and only a couple of weeks ago, it appeared we might be headed for smooth sailing. The rise of long-term rates throws that into question and has re-awakened markets to risk. The financial community will be on edge on Aug 25 as Chair Powell’s comments can tip the scale in either direction.
What We’re Reading
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China, Chinese Real Estate, dollaer, Inflation, Interest Rates, Jerome Powell, Mortgage Rates, Portfolio Diversification, Retirement, S&P 500, Stocks