Over the last 22 years I’ve made 4 major forecasts; when to get into the stock market and when to leave; when to invest in real estate and when to get out. Now I’m making another major call: high inflation is coming and it’s very important to understand what it will mean to you and what to do about it. High inflation means higher prices, yes, but it has major implications for your current investments and for your financial plans in general, so it’s best to position yourself in preparation for it now rather than getting caught losing big.
For the past 10 years inflation has averaged an artificially low 2.5%, vs. an average of almost twice that for the 30-40 years prior to that. It’s been about 30 years since we faced really high inflation and I remember it well. Over the course of 3 years prices rose an average of 7-8% per year for a whopping total of 25% increase. That could very well happen again. Imagine all of your expenses going up that much. If your income doesn’t rise to match, inflation can end up being a very serious problem.
Mortgages have the potential to be dramatically impacted by rising inflation. Interest rates will rise significantly with rising inflation and the difference between locking in at the current artificially low lending rate of 4% vs. a very likely 6-7% is a jaw dropping 50-75% increase. Imagine a mortgage payment that jumps 50-75%, and that’s what I believe we will be facing. So, if you’re among the millions of homeowners that do not have a long term fixed rate mortgage, I urge you to run, not walk, out the door right now and get one. If you do have or get one, then not only will you not be hurt, you’re likely to win, big-time, paying off your house with cheaper dollars in the future. As your income rises overtime with inflation and you’re making a third to half more (in inflated dollars), you still get to pay back the fixed amount you owe which is in old (un-inflated) dollars, dollars that are worth only a half to a third of the inflated dollars you’re making at that point in time. Now that’s a deal!
Next, if like most people you’re putting away savings in a retirement or other long-term account, its typical these days that half or more is in fixed income. This means that part of your portfolio is in fixed rate bonds, CD’s or other assets with a fixed rate of return. While there has been a good reason for this up to now given the state of the stock market, it’s not smart to maintain this going forward. Avoid getting your money locked into investments that will take more than about 12 months to mature or at some not too distant point you’ll end up losing as much as half that money or more.
To understand this, say you invest in (buy) a 20 year treasury bond paying 4% interest. Then interest rates go to 6% for a 20 year treasury and you want to sell it (probably to invest in the higher return bond). No buyer will pay you the full amount you have invested for a bond that pays 4% when they can buy one paying 6%. You will be effectively stuck with the bond for the duration or need to take a loss. You’ll have no choice but to cut your selling price until the amount they pay for it gives them a 6% yield on their money. In this instance your investment is now effectively worth 23% less. You will have just lost 23% of your money. The longer the time until a fixed income investment matures, the worse the drop in its value for each percent of rise in interest rates. If the maturity is shorter, the drop in value is less than it would be for one with a longer maturity. For example a bond with a 10 year maturity drops 13.5% if rates rise by 2%, rather than the 23% of a 20 year bond.
The bottom line is that a lot of money is likely to be lost for those that do not take the time to understand the effects of inflation and make sure your fixed income investments are changed to short term now before interest rates change much. It’s potentially nasty stuff, especially since I believe we’re looking at rates going up a lot more than 2%.
To learn more about the effects of inflation and what you can do about them, I recommend listening to Money Smart Radio this Saturday or, if you can’t, listening to the podcast that will be up at www.MoneySmartOnline.com/Radio by Tuesday, April 3, 2012.
My favorite adage is true once again when it comes to rising inflation. Understanding the problem is 90% of the solution. Once you do you’re in a position to do something about it. Inflation can be painful to think about—a good example is the rise in gas prices—and our first impulse is to avoid thinking about it. However, the last thing you want to is nothing. Time is on your side right now, so use it to your advantage. Listen to this week’s Money Smart Radio, then begin the steps that will be in your best interest, going forward.