Inflation

Why was a cup of coffee 10 cents in 1960 but over a $1 today? The answer- inflation. A Nexis search in 1996 found that inflation is the most commonly used economic term in the popular media. They found 872,000 news stories over the past twenty years that used the word inflation. “Unemployment” ran a distant second. Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

The Inflation-Recession Cycle.
Inflation often coincides with an economic boom and a good job market. The more people earn, the more they’re willing to pay—and compete—for goods. And, higher demand creates more jobs. But seeking to pay more workers and afford greater quantities of materials, manufacturers must raise prices.

Over time, prices can rise to a point at which salaries no longer keep pace with the cost of living and goods are less affordable. That’s when the dollar becomes “inflated” and its value declines. When demand goes down, companies begin to lay off employees and initiate pay cuts. Eventually, as companies struggle to stay in business, you may see great bargains and liquidation sales.

The primary job of the Federal Reserve Chairman is to fight inflation. The government cools down inflation by selling government securities, which raises interest rates—the fixed percentage paid to bond holders annually—and slows down borrowing. To avoid a recession, the government later reverses this policy. As interest rates go down and people start borrowing again, the demand for goods increases, the job market improves—and the cycle starts over.

Inflation and You
If you’re a highly conservative investor with significant assets in money market accounts, or a retiree who relies heavily on fixed-income investments—bonds, fixed annuities, and pension payments—inflation can pose a problem. As the cost of living rises, a fixed stream of income buys less and less of what you need to live comfortably.

In 2005, $100 had the same purchasing power as $4.59 in 1900, $9.54 in 1925, $13.09 in 1950, $29.22 in 1975, and $93.58 in 2000. But if you own a $10,000 bond that pays 5.5% you’ll get $550 per year, no matter what the dollar is worth.

You’ll also lose purchasing power if your salary fails to keep pace with inflation. The average American pay raise, one of several possible inflation indicators, trailed the cost of living by 2.3% since mid 2004, according to the Federal Employment-Cost Index.

While you can’t control inflation’s impact on your take-home pay, you can help safeguard your investments with an allocation to stocks. Since 1926, equity investments have returned an average of 11% annually, while inflation has averaged a 3.1% yearly increase. Diversified portfolios—with 60% in stocks, 30% in bonds, and 10% in cash—have earned a return at least four percentage points higher than inflation over the long term.

Yet while growth investments can provide the extra return you need to stay ahead, fixed-income securities help cushion the blow when the stock market drops. Although bonds may not outpace inflation by much, they provide steady, healthy returns.

There are securities that offer investors the guarantee that returns will not be eaten up by inflation. Treasury Inflation-Protected Securities (TIPS), are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increased to compensate for any inflation.

Like so many things in finance, the impact of inflation depends on your own personal situation. The debate among policy makers and economists on inflation’s impact at 3 percent versus zero percent is quite vigorous, at present, but no clear consensus has been reached.