By Brad Thomason, CPA
Oh inflation, you are some tricky stuff.
In principle, so simple that a school child can understand. In practice, so complex as to befuddle the collective brain power of economists, banking regulators and financial advisors, the world over.
Inflation is a topic in the news these days, for the first time in a long time. I think I saw a headline the other day that inflation is now at a 31 year high, or something like that. The type of inflation we are seeing right now is, at the moment, generally considered to be a temporary effect of the pandemic. First there were breaks in production at the beginning of the pandemic, followed by what is essentially a glorified traffic jam right now in global shipping. Net result, goods can’t get to market, supply goes down, prices go up. Econ 101 stuff.
I think it is fair to say that most prognosticators expect prices to go back to “normal” once the supply issues are resolved. I guess if I had to take a position (which I don’t, since I’m not an economist), I would say that seems the most likely of the possibilities.
But it certainly isn’t the only possibility. There are a couple of pretty significant data points that don’t fit so cleanly up under that thesis.
One is the fact that the price of oil has gone up quite a bit. And how much of that is attributable to delivery logistics is open for debate. For several years now oil has been trading in the lower end of its range. This recent move higher – still well short of the top end of the historical price range – is a somewhat naturally-occurring feature of the oil market. Yes, I’m sure there’s plenty of banter out there about this group wanting more production, or that country making some other decision. But if you turned off the news and looked just at the price chart, it wouldn’t jump out at you that anything overly extraordinary was going on. Commodities fluctuate up and down, over time, just because they do.
Oil not only impacts transportation costs, it is also a key input in a lot of products that you wouldn’t immediately think of as petroleum-based (fibers in clothing; corn, by way of fertilizer and tractor fuel, etc).
So if oil stays high, even after the supply chain is flowing smoothly again, those costs might still drive, or at least support, higher price levels.
Another possible factor is that wages have actually risen over the last few years, and one of the classic definitions of inflation is “more dollars chasing the same quantity of goods.” So that too argues for some persistence, maybe even permanence. Who knows?
In recent years, the year-to-year rate of inflation has not been particularly high, and I have had some conversations in which people asked me if that was really still something that they needed to worry about. I’ve always said yes. That’s gotten me some skeptical looks. But to think otherwise would be to think that a historical trend that is centuries old had, for some reason, stopped.
But I understand where the question comes from. What we are seeing on the inflation front, at the moment, certainly stands in contrast to what has been going on for the past few years. Which is the aspect of the topic I want to highlight in this post.
Inflation does not follow a smooth line of progression. Instead, it follows a pattern of surges and pauses.
When we model for it we usually use a flat rate each year. We do this because it is infinitely easier, mechanically; not because it necessary reflects what we expect to happen. Also, significantly, even though we don’t expect it to be perfectly smooth, we have zero insight into when the surges will come. So it’s not like we have a better version of the future that we could put into the projections, but just don’t want to mess with it. Which gets us back to the flat-rate assumption, which we know is unlikely to be right, but is nonetheless the strongest of the imperfect candidates available.
The fact that inflation changes from year to year has substantial implications for managing the years of retirement. Indeed, it is this variable nature of inflation that is a prime reason why we say you need to monitor what happens, replacing projected data with actual results each year, as those results occur, and then reassessing the overall situation.
Notably, the fact that investment result can be variable is actually less of a driver than inflation (and medical spending). That’s because in retirement, if you have down-shifted your risk level, you won’t have as much variance – if any at all - in your returns. That is in fact a big part of what ‘lower risk’ means in this context: higher likelihood of getting exactly the return you think you will get, as is the case with most interest-bearing instruments which are held to maturity.
So if we take all of that together, and we put in a meaningful assumption for inflation, then it is not as big a deal when we have a surge like the one we are seeing right now, whether the surge remains permanent or not. If you made projections five years ago, you would probably view current inflation as something of a catch-up to the inflation that was predicted for the four previous years, but never fully manifested.
Bottomline, inflation is still real and still something we have to account for. Moreover, even though we might put it into the calculations as a consistent force, we should keep in mind that it is not in reality. Doing so helps to keep things in perspective, and acts as an inoculant against sharing in the hysteria when the media starts writing headlines of impending doom and gloom. Like rainfall, inflation is just part of the natural landscape. You can spend a lot of time and effort trying to figure it out and predict it… and likely failing as often as you succeed. Or, you can just accept that it is, get an umbrella, and shrug your shoulders when it comes along. That’s my preference. Both for rain, and inflation.
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