The basic purpose of saving and investing today is to have funds to purchase goods and services in the future. You may have a near term goal such as buying a house or new car, or a more distant goal, paying for education or funding retirement. The key is what a dollar saved today will buy in the future.
Inflation is erosion in purchasing power. It took $1.61 to buy in 2013 what you could buy for $1 in 1993. It took $1.27 in 2013 to purchase what a dollar bought ten short years ago in 2003. Inflation expectations will color your investment strategies, especially potentially long-tailed aspirations like financial freedom in an age of increased longevity and uncertain health care costs.
Currently inflation expectations are muted, unless you watch commercials featuring an old movie actor by a fireplace warning of a coming “inflationary storm.” The easy monetary policy pursued by the Federal Reserve Bank (tagged “quantitative easing” or QE) plus government deficits will cause rampant inflation, he states in authoritative tones. Buy gold, he urges.
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Not such good advice, at least near term. The benchmark SPDR Gold Trust (GLD) has decreased in value by 26% in the year ended January 10, 2014. Commodity prices in general are down. Core inflation is running at an annualized rate of 1.7%. Inflation expectations going forward are in the 1.7% to 2% range.
The reality is that money growth does not cause inflation. Money growth accommodates inflation, eventually. So why hasn’t Fed policy ignited robust growth in the economy, increasing demand for goods and services that would allow prices to rise? Where is all of the liquidity? Corporations sit on record amounts of cash and they are wary of spending until more demand appears. But the real problem is complex federal regulation and cautious banks not lending.
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A 12/23/13 Economic Insights report from Lord Abbett indicated that despite a flood of liquidity, in 2010 under QE2, the second round of Fed bond buying and money creation, bank lending nationally fell by 5.8%. Since 2010, bank lending has grown at a tepid rate of 2.8% a year, barely pacing inflation. The report noted, “Lending has progressed so slowly that presently fully 95% of all reserves held by banks stand in excess of what they need to back their deposits and loans, a veritable ocean of unused liquidity.”
Banks don’t need to pay much interest to attract money and low interest rates penalize savers. Safe money yields are negative adjusted for inflation and taxation. So money sits in banks and on their books at the Fed and does not enter the economy. The velocity of money, the extent to which money is spent and turns over in the economy, still is quite low. Aggressive legislation like the Dodd-Frank Wall Street Reform and Consumer Protection Act has lenders in a cautious mode. Likewise, the Affordable Care Act has employers, especially small business, holding back in the face of uncertain health care compliance costs.
Wage growth is paltry, restraining cost-push inflation. The economy has significant unused production capacity so supply-demand inflation is not a factor presently. Consumers with smart phones are quick to compare prices and pursue bargains so pricing power is restrained. Beef prices up? Switch to chicken.
We don’t see interest rates and inflation accelerating rapidly anytime soon. But do not ignore the trend. Even at 1.7% inflation, a saver in a 25% average tax bracket has to gross 2.27% on an investment to break even. To achieve a 3% real return over inflation at 1.7% with a 25% average tax bracket, a return of 6.27% is required. You cannot make that in fixed income or with no risk. Inflation and taxes must be built into your investment policy, adjusted for your personal risk profile.
Assuming ample safe money reserves in place, investors will continue to look toward diversified equities and alternative investments to build future purchasing power. If you want $75,000 in retirement income in today’s dollars 15 years hence, at 2% annual inflation you will need $100,940 in income to buy the same basket of goods and services. Two percent...“that ain’t nuthin.”
Lewis Walker is President of Walker Capital Management LLC. and Walker Capital Advisory Services, Inc., a Registered Investment Advisor (R.I.A.) Securities and certain advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative of SFA which is otherwise unaffiliated with the Walker Capital Companies. ▪ 3930 East Jones Bridge Road ▪ Suite 150 ▪ Peachtree Corners, GA 30092 ▪ 770-441-2603 ▪ lewisw@theinvestmentcoach.com