Why a Spike in Inflation Could Hurt Your Ability to Save for Retirement
It’s important to save for retirement. Everyone knows that. Unfortunately, not everyone treats this fact with the seriousness it deserves.
One reason I stress the importance of saving for retirement at any age is because you don’t know what’s going to happen in the years to come.We may very well find that, shortly, inflation is about to spike which will most likely hurt your ability to save.
What is Inflation?
Before we talk about why you may find it hard to save for retirement if inflation increases, let’s first make sure everyone is on the same page about this economic phenomenon.
As a basic definition, we can look at inflation as the increase in prices of goods and services and the decrease of purchasing power held by currency. There are two main causes that are commonly behind inflation:
⦁ A rapid increase in wages (see the chart below)
⦁ An increase in the price of raw materials
Average hourly and weekly wages grew 2.7% in July 2016. This was the highest it’s been in over a year, as inflation appears to be running hot all of a sudden.
Over time, the creation of greater amounts of currency is also one reason for long-term inflation. This is why you hear about people once buying an entire house for under $1,000. Money used to be worth more.
One of the primary responsibilities of the Federal Reserve is deciding how much currency to supply the market in order to keep inflation at a minimum.
Toxic Mix of the Current Status Quo
Despite a low official inflation rate as measured by CPI (Consumer Price Index), real inflation is much higher. According to the U.S. Bureau of Labor Statistics, the Consumer Price Index for All Urban Consumers (CPI-U) grew by 0.2% on a seasonally adjusted basis in June. Over the last year, the all items index increased by 1.0% before seasonal adjustment.
However, if you look at the price change of the primary residence rent, you can see that it has been rising by 3.82% in June 2016 compare to the June 2015.
The similar story is about Education. One year price of education increase is 3.03%.
What does it tell us? It confirms that household spending on large tickets expenses such a primary residence rent, mortgage and children education are eating up more and more money from household budgets.
Rising inflation and falling interest rates currently offer a toxic combination for many savers. It means they could save for retirement less and less money.
In the same time, current interest rates paid by saving accounts and bond yields are on a historical level; saver can’t receive compensation that even exceed real rate of rising cost of living.
But what would happen if prices begin soaring in all sectors?
How Inflation Affects the Economy
By now, it’s probably fairly obvious why it becomes hard to save for retirement when real inflation is high, and interest rates are low.
However, a spike in inflation will affect the entire economy and not for the better.
When the price of things like food, energy, commodities and other goods and services goes up, the cost of living becomes much more expensive too. The same applies to the cost of doing business and taking out a loan.
Charles Hugh Smith, the author of Why Our Status Quo Failed and Is Beyond Reform, paints a far grimmer picture. In fact, he believes the public isn’t even aware of the real rate of inflation (which he puts at least 7%) because, if they did, the following problems would already have arisen:
⦁ Social Security beneficiaries would demand an annual increase to match this true rate as opposed to nearly 0% which it is at the moment
⦁ Global investors would demand yields on Treasury bonds that are greater than the 7% inflation rate
⦁ Private-sector interest rates would soar, crushing private sector lenders
⦁ Students wouldn’t accept loans that didn’t come with interest rates above 8%, which would be a serious problem when you consider this chart:
These are just four of the symptoms Charles Hugh Smith believes would be the consequence of the public understanding our true inflation rate.
While it may make the need to save for retirement look somewhat minor in comparison, it’s still important to appreciate that inflation is more than just some numbers on the chart or the slow, an almost unperceivable increase in prices over several decades.
It has the power to affect all of us and in a potentially dramatic fashion.
You’re Going to Need to Save a Lot More for Retirement
Some of you may have also noticed one of the biggest problems facing retirees when inflation is up from the bullet points above. You have to expect that social security payments will, essentially, not be worth as much, especially if Charles Hugh Smith is correct about the true rate.
Therefore, whatever your current goals are for retirement, regarding how much money you’ll need to save, it would probably be wise to add to those considerably.
If you’re in your 20s or 30s, it’s going to have to be still a lot more as inflation could rear its head several times over the coming decades, increasing the amount you need to live off of with every appearance.
The Price of Bonds Will Go Down
Another issue is that bonds will suffer from the rise of inflation. This is simply how the two work: inversely. If interest rates rise, bond prices plunge.
The short term effects will most likely hurt older people trying to live on retirement by withdrawing money from a retirement nest egg.
However, falling bond prices will increase bond yields, which will help those retirees who live on a fixed income.
A rising bond yield may help risk-averse savers, especially Gen X and Baby Boomers. As you get closer to the age of retirement, it makes more sense to invest the stability and consistency of bonds.
However, would a rising bond yield exceeds a real inflation rate yet to be seen.
After all, when you’re younger, you have a higher tolerance for risk and should have a diverse portfolio that matches this.
Opportunities for Investment Will Wither
Inflation is also poisonous to a country’s economy. Hopefully, by now, that’s relatively clear. The following graph helps show just how quickly this phenomenon can kill off businesses, though:
This is a good example of how inflation can hurt those who are still relatively young.
As it turns out, inflation doesn’t discriminate, though. Young people who are still trying to find a foothold, build a career and make a desirable income are going to have a very powerful force working against them if inflation spikes.
Even if they do find a job, their income will suffer and, thus, their ability to put money aside for retirement.
Trying to save for retirement should always be a goal, but some years it will be easier than others. If a rise in inflation is on the horizon, it’s best to understand this now so you can behave accordingly.
One critical takeaway from this piece should be that inflation comes for the young and the old. So even if you have a sizable nest egg with just a few years of work left, don’t get too comfortable. Likewise, just because you’re in your early 20s doesn’t mean you don’t have anything to worry about.
Taking saving for retirement seriously by paying attention to the market so you can see these types of things coming.