Inflation: An Insidious Threat Your Financial Independence Journey

Financial independence plans are coming under threat from inflation’s insidious rise. According to a government report, prices paid for everyday household items rose by 4.9% in May compared to a year earlier. Even when stripping out volatile components, like food and energy, prices were up 3.9% over the same period – the fastest in over three decades.

While these statistics might seem arbitrary at face value, it’s essential to understand the context. For example, the latest inflation figure comes in stark contrast to its 2.5% average over the past 30 years. Indeed, the reality of rising prices is evident whether you’re filling up the gas tank, shopping at the grocery store, getting ready to buy your next house, or decorating the home you just purchased. 

Permanent or Transitory?

Today, many economists, market watchers, and to be sure, households look at the recent price spikes and ask, “Is today’s higher inflation a fluke or new reality?” 

A Case for Lower Near-Term Inflation

Certainly, there’s a case to be made that inflation is likely to ease in the coming months. How so? Well, households globally today are spending faster than expected, and global distributors are struggling to keep up with demand. Last year’s global economic shutdown and ongoing COVID restrictions have created gridlock in the global supply chain.  These bottlenecks have made it harder to ship certain goods from international producers to US warehouses, crimping supply on store shelves and naturally putting upward pressure on prices.

For example, according to one report, container ships responding to the post-COVID consumer spending surge found it challenging throughout June to unload their goods at the Port of Los Angeles (one of the busiest ports in North America). In fact, some ships were anchored in a holding pattern for five days outside of the port, given logistics backlogs. In normal circumstances, foreign cargo ships typically don’t have to wait to enter the port and can unload their cargoes right away.

Why is this story significant?  Well, what makes shipping into the Port of LA important is that these freighters carry household goods and manufacturing components that affect all aspects of the US economy. Now, this logistics gridlock story is not unique to the Port of LA as it’s happening in ports all around the world. And these delivery slowdowns have led to a global supply chain crunch, giving way to higher near-term prices for a host of goods.

From this perspective, it could be argued that today’s high inflation is only transitory.  Once global logistics issues are fully resolved, near-term inflationary pressures might ease as the supply of goods finally meet the rising pressure from pent-up global consumer demand.

A Case for Higher Longer-Term Inflation

Now, while there’s a case to be made for lower near-term inflation, it’s also worth considering the potential factors that might lead to higher prices in the decades ahead.  Indeed, the Federal Reserve has flooded the economy with $5 trillion from the start of last year. Combine this excess money printing with trillions in government stimulus, and there’s a potential that excess household savings (coupled with a higher propensity to consume) might cause inflation to run hot for longer than what many economists anticipate.

To this point, researchers at Bank of America recently published a report noting that over the next four years, US inflation could average between 2-4%. If we look back through history, this estimate compares to average annual price gains, of around 3% over the past 100 years, 2% in the 2010s, and 1% in 2020. According to this report, analysts believe that a key contributor to faster inflation likely could come from Americans sitting on trillions of dollars in unspent savings.  As COVID restrictions ease and the economy rebounds, this savings could make its way back into the economy in the form of higher consumption and wage growth.

Another long-term inflationary point to consider is China’s evolving relationship with the rest of the world. Chinese factories have, until recently, been low-cost producers of the world’s goods, arguably contributing to low inflation in developed market economies for the past two decades.

Nevertheless, geopolitical tensions remain elevated between Western nations (notably the US) and China. What’s more, Beijing is pushing policies that would enable China’s economy to become more domestically reliant while expanding its political influence globally. From this perspective, it’s very well possible to see higher-priced goods here at home should Beijing’s policy changes reduce China’s export of deflation to the rest of the world.

Why Does Inflation Matter?

So, what’s the big deal if prices rise faster than expected? In other words, what role might higher inflation play in your ability to navigate your financial independence journey? Well, at face value, persistently elevated inflation could result in your spending down retirement savings at a faster than expected rate. How so? Well, a simple example here might help.

Let’s suppose that you’re planning to retire in 20 years with a lifestyle need of $60,000 per year in today’s dollars. Assuming a modest Social Security benefit, you’ll likely need to have saved about $1 million to cover inflation-adjusted living expenses over the next 30 years. This figure is based on a widely held industry assumption that inflation may average 1.5% over the long term.

So, what happens when the 1.5% average inflation assumption used in calculating your $1 million savings turns out to be 2.0%? Holding our earlier assumptions constant, a half-percentage point cost of living increase could lead to a savings shortfall of over $1 million throughout retirement. Put differently, $1 million of retirement savings might only cover about 20 years of living expenses should inflation average 2% instead of 1.5% in your original plan. 

Inflation and Your Financial Independence Journey

So, are higher prices here to stay? And more importantly, is the 1.5% inflation assumption used by many in the financial industry overly optimistic? Well, some argue that once supply constraints ease and the low base effects pass, inflation could return to the low levels we’ve seen in the last 10-year.

The truth is that in the period following the Global Financial Crisis, economists have had a terrible track record of predicting inflation. Certainly, easing logistics bottlenecks likely will reduce inflationary pressures somewhat in the coming months, but long-term risks remain.

To be sure, many structural changes are afoot, which argue against a return to “normal” inflation. The effects of Trade War tensions and China’s growing push for global political influence likely will have some impact on the country’s willingness to remain a low-cost producer of the world’s goods. Add to this the uncertainty surrounding trillions of dollars in US fiscal and monetary stimulus, and it’s likely that inflation will not fall back to 1% over the long-term.

Make no mistake; inflation is so insidious that even a seemingly minor change can have an outsized impact on your achieving (and maintaining) financial independence. When not adequately accounted for, it will slowly and subtly erode the purchasing power of your retirement savings.

Certainly, while inflation is likely to ease in the near term, it would nevertheless be prudent to evaluate whether your long-term inflation assumptions are overly optimistic and if they are, to make adjustments accordingly.  Doing otherwise may just end up cutting short your journey to financial independence.