In financial circles, there's been a lot of talk about inflation. The Fed wants to encourage a moderate inflation increase and is holding interest rates low until that happens. Pessimists, though, worry about that approach. The thinking is that pent-up demand from the pandemic lifestyle could drive a sudden rise in spending once COVID-19 is under control. That influx of money into the economy would push prices higher -- potentially driving inflation above the Fed's target of just over 2%.
A short-term period of slightly higher inflation wouldn't be memorable, but an extended run of inflation above 3% can be problematic. It raises your cost of living and chips away at your investment returns. Inflation can also increase the cost of new borrowing. First, lenders may want to charge more to offset the value they lose to inflation by the time their debtors repay. And then, the Fed may deploy its go-to move to combat inflation, which is to raise interest rates.
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To be clear, I don't expect catastrophic inflation anytime soon. But it doesn't hurt to bolster my finances ahead of uncertain economic times. Here are three steps I'm taking to prepare.
1. Continue to invest in the stock market
Equity investing is an effective inflation hedge because the stock market tends to outpace inflation. That dynamic holds over long periods of time, though it can fall apart in the short term if inflation spikes. Rapid inflation is tough on businesses -- they absorb higher prices, too, and have to use more cash to maintain the same level of productivity.
You can play defense in your portfolio by investing in companies that are poised to march through an inflationary period mostly unscathed. These are companies that already produce ample cash and can raise their prices without losing customers. For example, you'll keep buying toilet paper and milk, even at higher prices. You'll also keep paying your utility bills and buying your blood pressure medication. But you may be less willing to eat out, though, if a hamburger suddenly costs you $20.
Companies that produce, distribute, or sell necessities can do well in inflationary times. Discretionary products and services are more likely to falter.
2. Rethink the emergency fund
It's hard to hold a bunch of cash in a savings account when the value of that cash is falling rapidly. For that reason, many experts will tell you to dump your cash when inflation is on the rise.
I'm taking the opposite approach, and adding to my emergency fund. Here's why. Right now, my emergency fund is pretty lean because I can borrow money cheaply. Inflation blows up that plan in two ways. One, if prices are rising, my lean balance will definitely be insufficient to cover living expenses after an income loss. And two, rising interest rates would take away the option for cheap debt.
So, I'm adding cash, mostly for my own peace of mind.
3. Review debt balances
Speaking of debt, inflation can be good or bad for your finances if you owe money. On one hand, you can repay your debt with money that's worth less than the money you borrowed. But you could see rising interest expenses on your variable-rate credit card debt.
Rates are still low, so now might be the time to review your highest-rate debt balances and find opportunities to refinance or consolidate into fixed-rate loans.
Shore up those finances
Inflation may be a factor in the coming months. Chances are, it'll be temporary and, hopefully, uneventful. You can prepare by derisking your portfolio while continuing to invest, adjusting your emergency fund strategy as needed, and shifting away from variable-rate debt. In short, shore up those finances. If the economy goes sideways for a minute, you'll be glad you did.
