Inflation: the Risk of Holding On

Especially trailing the Great Recession, many individuals are tempted to hold onto their savings in the form of cash or cash equivalents in an attempt to preserve their value. There’s no risk in this, right? In reality, this may not be the wisest decision to preserve your wealth, as the average inflation rate has traditionally hovered around 3%. This means that the dollar in your hand will lose 3% of its purchasing power within the next year; you will be able to buy 3% less stuff with your money a year from now. Yet, though it may seem counter-intuitive, this situation is highly preferable to the alternative—deflation—and nicely aligns with the Fed’s goals of stable prices. Investing the majority of your assets where you feel comfortable (whether that be bonds, ETFs, equities, etc.) and especially seeking a financial advisor’s advice is by far your best shot at preserving and growing your wealth.

Why is slight inflation preferable? Inflation is “the rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling,” as the wonderful Investopedia explains. In order to facilitate this inflation, the Fed exercises an “elastic” currency, meaning that they print money out of thin air (the value of money is not tied down to a gold standard.) Although it may seem counterintuitive, this allows the Fed to rapidly react to changes in the economy and prevent the dollar from deflation, which is the worst case scenario. Deflation, which occurs when there is a shortage of money resulting in an overall fall in prices, is dangerous since it “results in lower prices being forced upon the market which are not the result of normal market forces” (“Why Deflation Is Bad And Inflation Is Good: Monetary Policy 101.”) This is really bad for people looking to borrow money, so essentially all of us if we someday wish to make a big purchase, because lenders will definitely want to hold onto their cash since it will be worth more in the future than it is currently. As you can deduce, deflation spells disaster for interest rates. If inflation goes up, interest rates can go up as well to naturally lower demand for borrowing money and keep the economy from hyper-inflation. But, interest rates are not able to go below 0%, thus deflation, and the economy is stuck in a downward spiral where no one wants to spend, much less loan out, money. To quote the previous article, “once an economy slips into a deflationary spiral, there is little the Fed can do, and that is why they deliberately error on the side of caution and generate a bit of inflation. It is simply an insurance policy against the destructive consequences of deflation.”

How do I beat inflation? Unfortunately, since most bank accounts offer really low interest rates for savings, usually around 1%, holding the primary amount of your wealth in cash means that since it’s not growing past 3% to make up for inflation, it’s shrinking. The Forbes article, “Why It’s A Bad Idea to Keep Your Retirement Savings in Cash,” highlights the reality that “in a sense you’re actually losing money every year. ‘The cost of goods and services goes up every year by about 3% on average, as inflation,” says David Blaylock, a LearnVest certified financial planner™ in Fort Worth, Texas. “If you’re earning 1% on your money in a savings account, you’re arguably losing purchasing power every year due to inflation. Growth isn’t even a possibility.’” To begin handling your assets with greater diligence, a good rule of thumb is to look at keeping about six to nine months of savings liquid in case of emergency. From there, assess your personal risk tolerance and look outward to investing and safeguarding your savings through slowly investing it back into the market where you feel comfortable. Luckily, in our developed society we have access to many great financial resources to guide us in this process, the foremost being a personal wealth advisor.

In conclusion, investing does not have to be a risky gamble embarked upon by the ambitious wealthy, rather it is a great way to safe guard against inflation risk while providing the opportunity to gain additional value on your savings.

Advertisements

Understanding Financial Decisions in Light of Opportunity Cost

“One of the key lessons of the recent financial crisis is the importance of personal financial literacy. Besides improving their personal financial decision making, teaching students economic principles will help them as citizens understand and make choices about many of the critical issues confronting our nation.” –Ben Bernanke, Chairman of the Federal Reserve System.

Just like other healthy habits, patterns of smart financial decisions include adopting a new mindset. When it comes to money, this frame of mind comes from looking at each personal financial decision in light of opportunity cost. Opportunity cost is crucial because we value other things besides money, think time and energy, and we must take them into account when we assess a choice. It looks beyond the direct monetary costs in each decision to the indirect costs, what you lose when you chose one alternative over another.

For example, imagine that you are at your favorite restaurant on Friday night and confronted with the decision of which dinner to choose. You’ve had a long week at work and are tempted to choose the $20 steak meal, but you also could be satisfied with a sandwich which costs only $10. Additionally, there is a new movie out that you wanted to see sometime this weekend. If you keep opportunity cost in mind, you are able to assess the choices more clearly, beyond the here and now, since you realize that you would be giving up both the sandwich and the movie for the enjoyment of the steak meal. So the question is: which allocation of resources will make you happier overall?

In the big leagues, opportunity cost becomes an even bigger player when it comes to purchases like a car, house, or college education. You can weigh the pros and cons, stare at your bank account, but a clear understanding of the next best way that you could allocate your money is a necessary thing to grasp. All decisions require sacrifices, and being able to visualize the alternatives to a course of action will serve you well when deciding which sacrifices you are most willing to make.

To conclude, opportunity cost, defined by Investopedia as “the benefits you could have received by taking an alternative action,” is an essential tool to help you make the best use of your money and resources.

Breaking Down Monetary vs. Fiscal Policy

An all-to-often overlooked way that people can affect their financial wellbeing is through their vote. One of the cornerstone concepts to grasp about the Great American Experiment is the distinction between fiscal and monetary policy and the fundamental role that each has in shaping our economy. Having a handle on the big picture, jargon, and responsibility of each will assuredly make you not only a better citizen but a better custodian of your personal wealth, which operates by the careful mechanisms of monetary and financial policy.

Monetary Policy

Our monetary policy is the job of the Federal Reserve. In fact, Congress has mandated that the power to direct our monetary policy be free from political influences, for obvious reasons. Therefore, beyond the congressionally decreed goals of “maximum employment and price stability as the macroeconomic objectives for the Federal Reserve,” the Federal Open Market Committee (FOMC) employs their policy tools independently to achieve those ends (federalreserve.gov). A taste of the tools that the FOMC has at their disposal is the reserve requirement, the discount rate, and open market operations:

  • Reserve requirement: defined by the Federal Reserve as “the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.” In lay people’s terms, this is just measure to regulate the amount of cash a bank can lend out to control the amount of cash available in the economy.
  • Discount rate: defined by Investopedia as “the interest rate charged to commercial banks and other depository institutions for loans received from the Federal Reserve Bank’s discount window.”
  • Open market operations: defined by the Federal Reserve as “the purchase and sale of securities in the open market by a central bank…to adjust the supply of reserve balances so as to keep the federal funds rate around the target federal funds rate established by the Federal Open Market Committee (FOMC).” The federal funds rate is the technical base rate behind the interest rates, or cost of borrowing money, in our economy.

The goal of price stability is achieved through controlling interest rates by means of these various tools and traditionally they pursue a target of a slight inflation rate of 3%. As you may be aware, the Fed generally pinpoints maximum employment at the “natural unemployment rate” of about 5%, to allow for frictional and structural unemployment, both of which are healthy in the cycle of job searching.

Fiscal Policy

Our fiscal policy exists in the realm of Congress, and refers to the manner in which they implement specific legislation in order to influence the U.S. economy. Their legislative powers fall into two huge categories: revenue collection (taxes) and spending. With every action taken, whether it is the purchase of goods and services, collection of taxes, or transfer payments, Congress attempts to reallocate resources within the economy to their highest valued use to society as a whole. This is crucial because while our free market economy is generally good at efficiently allocating resources to their highest valued uses, we naturally have other concerns such as equality and positive or negative externalities that are not taken into account by the market price of a good or service.

Fiscal policy is characterized as tight (or contractionary) when the revenues exceed the spending and the budget is in surplus, and loose (or expansionary) when the spending exceeds the revenues causing a budget deficit. In layman’s terms, tight fiscal policy is when the government will increase taxes and/or reduce spending, causing the budget deficit to shrink with the extra revenue. A loose fiscal policy will be designed to cut taxes and/or increase spending and usually causes the budget deficit to grow. The Concise Encyclopedia of Economics further clarifies that, “the focus is not on the level of the deficit, but on the change in the deficit.” Overall, fiscal policy is crucial for successful stabilization of the economy, as it has the power to affect aggregate demand, or raising the demand for goods and services since the government becomes a buyer in the markets.

Their Relationship

Clearly, both are extensively interrelated and rely upon each other to provide the framework for our economy, where the American Dream continues to true in each generation. The Federal Reserve’s webpage reminds that, “the FOMC considers how the current and projected paths for fiscal policy might affect key macroeconomic variables such as gross domestic product growth, employment, and inflation. In this way, fiscal policy has an indirect effect on the conduct of monetary policy through its influence on the aggregate economy and the economic outlook.” Jointly, Congress and the fiscal policies which it imparts are directly influenced by the interest rates and such that the Fed controls.

Conclusion

Since the average citizen has a low incentive to become sufficiently educated on such topics, this quick reference ought to be useful in making it easier for our vote to more faithfully represent our actual desires. It is important to understand both fiscal and monetary policy since each has not only direct but unintended consequences on the financial wellbeing of ourselves and those we love. Though our political voice can only affect our representatives whose legislation makes up fiscal policy, understanding monetary and fiscal policy, which are essentially the rules that we play by in our economy, will only bring greater clarity and order to our financial decisions.