Understanding Inflation in 2021: What Investors Need to Know

Following a year of economic instability, many Americans are turning their attention to something that’s been around for decades, but has recently piqued national interest - inflation. Recent search data indicates that people are Googling the word “inflation” at rates not seen since 2011.  Since the start of the COVID-19 pandemic, six major stimulus bills totaling around $5.3 trillion have passed. Many wonder if these efforts to alleviate pandemic-fueled financial strife will impact inflation.

Fed Chair Jerome Powell has said that inflation is likely to pick up as the economy recovers from the pandemic, but he believes it will be temporary. Powell has also stated that the central bank plans to keep short-term rates anchored near zero through 2023.¹ 

Here’s a refresher about what inflation is and how it can affect you and your investments:

What Is Inflation?

Inflation is defined as an upward movement in the average level of prices. Each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.

Understanding the Consumer Price Index

The CPI is a measure of the average change over time in the price of a hypothetical "basket" of consumer goods and services from the following categories:²  

• Food and beverages
• Housing
• Apparel
• Transportation
• Medical care
• Recreation
• Education and communication
• Other groups and services

While it’s the most commonly used indicator of inflation, the CPI may not always present an accurate picture of the economy as a whole. For example, the CPI rose 1.4 percent between January 2020 and January 2021 – a relatively small increase. A closer look at the report, however, shows the movement in prices on certain goods tells a very different story. Used car and truck prices, for example, rose 10 percent during those 12 months.³ 

Investments & Inflation

Inflation can affect investments in several ways. Most notably, it reduces the real rate of return and affects purchasing power.

Rate of Return

Inflation reduces the real rate of return on investments. Say an investment earned 6 percent over a 12-month period. During that time, let's say inflation averaged 1.5 percent.  The result is a real rate of return of 4.5 percent - the nominal rate of return less inflation.

Purchasing Power

Inflation puts your purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer goods and services.

Monetary Policy

The Federal Reserve controls monetary policy in the U.S., and typically targets an inflation rate of 2%.  In order to stimulate economic growth after the Covid-19 pandemic, the Fed has employed "loose" monetary policy over the past year or so, including lowering the Fed Funds rate.  If the Federal Reserve wants to control inflation, it may use one of several approaches to "tighten" monetary policy and reduce the amount of money in circulation.  Hypothetically speaking, a smaller supply of money means less spending - which could equal lower prices and lower inflation.

In light of recent unprecedented events, it's no wonder that investors and consumers are concerned about the rate of inflation today.  As the effects of the Covid-19 pandemic subside, the Fed will seek to balance economic growth and inflation.  We continue to monitor these changes, and to ensure that our clients hold durable, well-diversified portfolios that serve them well throughout varying economic conditions.