Financial headlines have been abuzz with talk of inflation this year as prices increased at their fastest clip in three decades. This has led to an important question about whether prices will keep rising at a fast pace.
At issue is the recent pace of about a 5% increase versus an average of about 2.4% over the last 30 years. So 2% vs. 5%, it begs the question: why care?
Small differences in rate can lead to huge differences over the years, thanks to the wonder of compounding.
Think of it this way. An American who paid $1,000 for rent, gas, food, and everything else in 2000 could today, buy the same lifestyle for $1,590. If the average rate was 5% over that time, the cost would be $2,785.
That big difference is why a lot of economics professors are wringing their hands over whether higher inflation will end up being transitory or persistent.
Arguments for transitory inflation include a one-time rebound effect and lifted constraints on temporarily snarled supply chains. Both of these impacts can be seen in the limited supply and red-hot prices for cars.
Arguments for persistent inflation center around empowered labor. Labor prices show up in inflation by being both cost embedded in what we buy and an increase to demand through the higher wages paid to workers. It’s a potential inflation double-whammy.
The last three decades have been fantastic for inflation and horrible for labor – it took 30 years for real (after-inflation) median household income to increase by 11% from 1989. Over the same period, the real return on the S&P500 was 966.35%.
Inflation risk can be tricky for investors as inflation normally results in higher interest rates which can batter the prices of nearly all assets. One of the few places to hide from short term spikes in interest rates is cash, confoundingly the asset most at risk from long-term inflation.
If given the choice, many investors may still choose a bumpier investment journey than another three decades of stagnant real wages for their countrymen. If only we could choose.