Among the topics that receive attention in the world of personal finance, inflation was for many years near the bottom of the list. Between 2010 and 2019, inflation was so low, averaging just 1.8% per year, that the Federal Reserve was actually struggling to lift it. Throughout 2019, the Fed lowered its benchmark interest rate multiple times, citing inflation that was running below its preferred level of 2%.
But just a few years later, in the midst of Covid, this all changed. In the summer of 2022, inflation hit a peak above 9%, prompting the Fed to reverse course, raising rates in an effort to rein in inflation.
These efforts have been successful, with the most recent Consumer Price Index reading at just 3%. This episode, though, reminds us that inflation can be a serious issue, so it’s worth taking a closer look.
The earliest recorded instance of inflation was under the reign of Alexander the Great. In the fourth century BC, when Alexander’s army conquered Persia, it brought back enormous amounts of gold and silver. The precise amount is difficult to determine, but one calculation estimates that it was the equivalent of trillions in today’s dollars. It was this influx that created inflation at home for Alexander, and this helps us to understand one of the three main causes of inflation.
In technical terms, the situation that plagued Alexander’s Greece is known by economists as “demand-pull” inflation. With its newfound wealth, Alexander’s government began to spend freely. Writing in The Treasures of Alexander the Great, historian Frank Holt describes how money was spent on lavish gifts, public events and construction projects. Alexander founded 13 new cities, the cost of which Holt refers to as “incalculable.” The result was that everyday citizens had more money to spend, and that led to rising prices. As I mentioned a little while back, the Roman empire fell into this same trap. By reducing the silver content in each of its coins, the emperor was able to effectively “print money.”
Though it was for a different reason, this was not unlike the stimulus payments that the U.S. government issued during 2020 and 2021. While some of that money helped workers who had lost their jobs as a result of Covid, this cash was distributed somewhat imperfectly. Many people who had not lost their jobs nonetheless received windfalls, and this led to the same phenomenon of consumers feeling flush and thus able to overspend. It was for this reason primarily that both the stock market and the housing market jumped in 2021.
But stimulus payments were just part of why inflation spiked in 2022. You may recall the near-daily headlines about “supply chain issues.” That was the second factor. Beginning in 2021, as a result of the pandemic, certain components, especially for automobiles, were in short supply. That made cars difficult to get, allowing dealers to charge list prices for the limited number of cars that were available. Other factors, including Russia’s invasion of Ukraine, which impacted global shipping, contributed to shortages of goods at the same time. Because these types of shortages drive up costs across the economy, economists refer to this type of inflation as “cost push.”
As a result of Covid, in other words, global economies experienced inflation due to factors on both the demand and supply sides. This created a dangerous situation because it was on its way to becoming what economists refer to as “built-in,” and that is the third type of inflation. When prices are high, workers demand higher wages to keep up with those higher prices. But in order to pay workers more, businesses need to raise their prices, and this can lead to a cycle of wage and price increases. Once a cycle like that gets going, it’s very difficult to stop. That fear, I think, explains why the Federal Reserve was so aggressive in raising interest rates and why it’s been so hesitant in lowering them again.
At the same time, the Federal Reserve does want some amount of inflation. In fact, the Fed has an explicit goal for inflation of 2%. Given the problems that inflation can cause—some argue that inflation caused the fall of the Roman empire—you might wonder why the Fed would want any inflation at all. That, in fact, was the reality for centuries in Europe, where prices generally didn’t change at all from year to year. When inflation did enter the picture, very modestly, in the 1500s, it caused significant social upheaval.
So why, despite the risks, does the Fed want to see some modest inflation each year? There are a number of reasons, but economists generally focus on one: If inflation falls too close to zero, a risk is that it can actually fall below zero, into deflation, when prices fall from year to year. The reason deflation can be a problem is subtle. If consumers expect prices to be lower in the future, then they might choose to delay purchases, with the hope of paying a lower price next week or next month. This causes businesses to lower prices in an effort to entice consumers, but that has the effect of compounding the problem.
Over time, deflation can lead to stagnation in an economy as consumers delay purchases for as long as possible. In contrast, when prices rise modestly over time, there is no incentive to wait, and that helps to keep an economy moving. This risk isn’t just theoretical. For most of the past 25 years, Japan has struggled with deflation, and this has led to what observers call Japan’s “Lost Decades.” Prices have only recently turned positive, but it’s been a terrible period, and this is what the Fed wants to avoid.
What lessons can we draw from all this? First, it’s a reminder that we should never be too sure about what the future holds. When the Fed was struggling with inflation that was too low in mid-2019, no one would have guessed that just three years later policymakers would be contending with the opposite problem. Since no one—not even the Fed—can see the future, the most important thing, in my view, is to simply remain diversified. Fortunately, there is a simple formula.
Starting on the bond side of a portfolio, there are Treasury Inflation-Protected Securities (TIPS). These are government bonds that are guaranteed to increase in value at whatever the future inflation rate is. TIPS have a close cousin known as Series I Savings Bonds, or “I Bonds.” These function mostly the same way, but at any given time, one or the other will tend to offer investors a better yield. Today, I see TIPS as the better bet.
What else might you hold to guard against inflation? In 2022, when inflation was rising, stocks dropped. That might lead us to believe that stocks do poorly when inflation is high, but that’s not entirely true. While every company is different, some have more of an ability to raise prices than others. Those that have this flexibility are able to navigate inflation quite well. Looking back at 2022, when inflation was at its worst, companies on average were indeed able to raise prices. This could be seen in their gross margins, which measures the difference between their costs of manufacturing products and the prices at which they’re able to sell them. When I looked at the data in late-2022, gross margins had increased during that inflationary year even more than they had, on average, in the last pre-Covid year. This helped to support those companies’ profits. And because ultimately profits drive share prices, this is a reason why I see stocks as a very reasonable hedge against inflation.
