Chances are, neither you nor I have experienced during our careers an inflation rate that matches today’s stunning 7% readings. We may be in uncharted waters, yet we can also begin to chart a path towards building financial plans that stand the test of such hot inflation rates.
Broadly speaking, prices are rising more than they have in the past 40 years, which leads to the question: At what point would inflation become so abnormal that it would be time for an advisor and client to start talking about changing financial plans?
Hopefully, it doesn’t get to that point. One or two years of abnormally high inflation that then returns to something resembling normal shouldn’t have too much effect on a client’s long term financial plan.
We at Horizon Investments are still optimistic that countervailing forces are gathering strength to throw cold water on inflation. We see glimpses of those countervailing forces in rising company inventories, a shift in consumer spending to services from goods, a rolling over in transportation costs, more people re-entering the workforce, and the start of a Federal Reserve rate-hike cycle. But our optimism is tempered by the fact that housing and rent inflation is still strong and that prices generally are not rolling over.
While you and I may have never experienced today’s inflation rates, we have been professionals long enough to know that nothing is constant in the financial world. Trends change, and sometimes that change happens quickly. Inflation is no different. Today’s hot print could turn into tomorrow’s cold streak.
The silver lining of today’s inflationary environment may be that it causes advisors and their clients to base financial targets on long-term inflation rates, rather than on the low rates of the recent past or on today’s elevated numbers.
What we think advisors should know about inflation–and that we doubt you’re reading in the media–is that it’s typically volatile and mean-reverting.
What impact does that have on advisors as they’re formulating financial plans? Let’s look at a specific example that could apply to a broad set of financial targets.
Let’s assume that a goal-based client wants to buy a second home in 20 years. Let’s further assume that the house they like is currently worth $350,000. What is a reasonable monetary target for this goal?
We approached the answer by calculating the cumulative, average, year-on-year long-term percentage change of the Case-Shiller National Home Price Index1 – currently 3.88% since the index’s inception in 1987. With that information in hand, it’s a reasonable planning assumption to use a roughly 4% inflation rate to set a future home price objective. In this example, it would be a good idea for the client to shoot for a housing nest egg of $800,000.
But thinking through the problem further, a question arises: does that 4% assumption hold true over the limited time our client has to reach their goal? After all, they don’t get to choose the circumstances in which they live.
So, we went back to our Excel spreadsheet and calculated the cumulative, 12-month percent change in home prices for three different 20-year periods.
Whether that goals-based investor started their journey in 1990, 1995 or 2001, we found that using a roughly 4% long-term inflation rate served them well. We say that because the cumulative percent changes were 3.02%, 3.61% and 4.22%, respectively, despite home prices taking very different paths during each time period (see chart below).
The 1990 goals-based investor (the blue line) may have initially felt they were saving too much as home prices fell; but the ‘’good’’ times didn’t last as home prices bounced back during the back-half of their financial journey.
The 2001 investor (the gray line) may have had the opposite feeling, thinking they were saving too little as home prices galloped higher in the early years of their journey during the housing bubble. However, the bust that followed unraveled what had occurred early on.
The 1995 investor (the red line), experienced a path that was somewhere in the middle of the two with pricing rising for the first half and decreasing the latter half. All of which ended their 20 years period hovering around the average of 3.88%.
Calculations: Horizon Investments
From Housing to Broad Inflation
Broadening it out from the housing specific example above, the overall price level index most commonly discussed in the media, the Consumer Price Index (CPI), also has been volatile and mean-reverting over the last three decades.
To show that, we calculated the average CPI year-on-year change over 30, 20 and 10 years – including the current eye-popping readings. Would you have guessed that the rate is nearly the same for all three, clustering around 2%?
The exercise begs a question: Why are CPI or housing prices mean-reverting? Let’s turn to a rule of thumb from high school physics to help find the answer. If you’ll remember, the rule is that for every action, there is an equal and opposite reaction.
Raise prices high enough and customers typically react by buying less or not buying at all, buying in bulk to get a discount, substituting a cheaper product, or seeking out another vendor who’s figured out how to deliver a better or comparable product at the same price.
And don’t think the Federal Reserve won’t react either. It is committed to raising interest rates this year to cool inflation. The higher interest rates rise, the more economic activity is choked off, which could dent inflation. The danger from the Fed’s rate hiking path is that higher rates have historically caused recessions. Yes, that would take the steam out of inflation–but the cost may be painful in terms of the potential for lost jobs, interrupted careers, bankrupt companies and financial stress.
Real life is messy. All of those things, and probably others, are happening as we speak. Consumers, businesses, and central bankers will reach a breaking point regarding higher prices. They will react, perhaps in surprising and unpredictable ways. And so we are reluctant to make forecasts. We would rather watch to see how the economic data and consumer behavior evolve over the months ahead.
What are goals-based planning lessons from our inflation exercise?
We’ve attempted to show that in the case of inflation, volatility can be an advisor’s friend.
1 Cumulative means that with every new datapoint the average percent change is recalculated using all of the data in hand.
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