“Do you know how much I paid for gas yesterday to fill up the van?”
“Ugh… The amount you say can’t shock me anymore. I can only imagine. How much?”
“$126! We were paying almost half that all summer… Hun. Get over. There are cars behind us.”
At least, that is the conversation I imagined these two cyclists were having on their way to either their next or last stop. Honestly, I should probably publicly apologize for all that stuff I said about them when they were holding up traffic. I guess that I should also confess that my road rage can get out of hand.
Seeing those two made me wonder about how bike gears work. What exactly is that gear shifter doing? When reading up on it, I realized how the Federal Reserve and cyclists are not all that much different.
Take this bike expert’s word for it, saying that gears allow them to hold a comfortable pedaling speed (or cadence) regardless of the gradient or terrain.
The more I read about how gears work the more I understood how cyclists use their gear shifters to control how much effort and energy they use based on their terrain and elevation. Much like how the Fed uses its tools to either spark or tame our nation’s growth based on the economic environment.
One of those tools is the interest rates the Federal Reserve uses to bat down high inflation. Here is why high inflation is so bad but may have some good to it, and what to do about it.
Where Are We Now?
The lower gears are only good for going from stop to start and pedaling uphill. Leaving the higher set for coasting and going downhill, to avoid pedaling out of control and wiping out. Right now, it’s like we’re at the top of the hill.
The problem is, as we transition downhill, we’re head first facing a wind tax. Our inflation is well above the desired 2% range, currently sitting at 7.5%. Like the wind, at one point it went almost completely unnoticed. Whereas now it’s overly prevalent and just adds more resistance to every stroke. Six months ago, seemed like the stock market reached new highs almost every day. This is not the case anymore because the market comes across as if it peaked in November.
Inflation hasn’t been this high since the early 1980s. Although this is not unprecedented – before then, it had been 65 years before it even reached those same levels – it is also not a regular occurrence.
Hence why the Fed is adjusting the gears a bit higher, allowing the rest of the economy to coast downhill.
Why is Inflation So Bad?
For the younger crowd like myself, outside of gas and groceries being more expensive, the worst part about inflation is rising housing costs. You have to live somewhere, right?
After enjoying what I used to call “Covid prices,” rent prices are going back up here in New York. I know that when my lease is up this year, I will have no leverage to keep the same rate. I’m stuck wondering whether I should pay more for the same to avoid the headache of moving, or find a cheaper place with fewer amenities. And what sucks about paying more to live in the same place is that it also makes it hard for us to save and level up, like buying a house. But recent home buyers and want-to-be buyers already know this. Real estate has been a nightmare for too long, and despite interest rates rising, 2022 may not show much promise of curbing the ridiculous demand.
This is mostly true for Gen Z and Millenials, but what about on the other side of the spectrum? Imagine having to pay more for everything, yet not have any income coming in.
It should make sense that retirees and soon-to-be retirees hate high inflation compared to the generations following them. Without the benefit of regular income coming in, the older generations are the ones whose purchasing power is more at risk. Their portfolios typically tilt more towards fixed-income assets. So then where could they get their income?
Well for some, bonds. If it is not coming from old pensions, social security, annuities, or rentals, it’s coming from their portfolios.
Remember our hill? Well, the Fed has been in the lowest gears possible for so long because there was only one direction to go – up. Although, the problem with the Federal Reserve moving too quickly to raise the rates is that it could invert the yield curve. Batnick does a much better job of explaining why is this is so bad, but all you need to know is that a recession and inverted yield curves like each other. Really like each other.
Although what is weird right now is that typically when the entire market goes down, investors clutch their purses and flee to safer investments. Increasing the price of bonds, providing diversification and stability for bond-heavy portfolios. However, historically speaking, when interest rates rise, short-term bond prices fall and investors will want to move to more risky assets, i.e. stocks. We’re in the unusual circumstance where they’re moving in step with each other – downward.
It’s either fight or flight. Leaving those who chose flight nowhere to go. So then how do you fight against the silent wealth tax?
How to Defend and Exploit Inflation
Whether you’re close or not too close to retirement, finding a clear downward path to gain momentum is your only shot at protecting your purchasing power. You have to own assets that outpace inflation, cash just isn’t going to cut it.
Back in the 80s, you could invest in safe assets, and get a decent rate on your money. In 1980, a taxable money market account was yielding as much as 12.68%!
Today, don’t even think about it. Savings account rates are a joke and safe bond yields become negative in real terms, meaning, you have to take on more risk for similar returns.
What about digital assets like cryptocurrencies? Sure cryptos have had astronomical returns in the past, but that’s been in a relatively short-term window. With that, cryptos have only ever existed in a low-interest-rate environment. Although Bitcoin has had its own bear markets and recession, it’s never been through a full-blown economic recession, therefore we don’t exactly know what cryptocurrencies will do. There is just not enough data and evidence to definitively say “cryptos are a hedge against inflation.” Although, that is not to say they don’t make a great diversifier.
As for the debate for growth versus value stocks, both provide good arguments for why they belong in your portfolio. When rates rise, growth stocks, which are usually highly leveraged, have to pay more to service their debts – affecting their earnings – leading to a dramatic fall in prices. Which can be dreadful if you bought at the top, but at least it does provide a more ideal buying opportunity. On the other hand, value stocks do have the data to show a sturdy track record against our wind tax. Value stocks are typically made up of staple names you’re probably familiar with even if you’re not an avid trader. This means their revenues don’t get hit as hard and they will continue to spit out dividends. This is just all the more reason why having a diversified portfolio is a win-win, even when you lose.
But maybe there is at least one silver lining to inflation. Yes, everything gets more expensive but on the bright side, at least you’re still making income. See, wages tend to rise during inflationary environments. Salary budgets are estimated to increase as high as 4% this year, compared to 2.6% this time last year.
This is important is because wages tend to be sticky. Once they go up they rarely go back down. Yet, consumer prices are riding through hills and valleys. Meaning they eventually peak and fall while your wages may have a linear, stairstep, or exponential slope.
Which Bike Are You On?
As we speak, the gears on our fictitious bike have been twisted back. The federal reserve has begun the first of several scheduled rate hikes this year.
In hindsight, it’s not hard to see how this all materialized. Chairman Powell took an offensive stance with Congress to bolster the economy during the pandemic. Rightfully so. However, once we were on clear, open roads, we should have raised our gears a bit to coast. But once you tack on sustained low-interest rates, employment and supply chain issues, and a war; inflation was bound to catch up to us.
For young earners, in addition to owning those same assets to keep up with the wind tax, you have the added benefit of income. Don’t underestimate the power of income in times like these. Although, regardless of how much income you are or are not bringing in, sitting in cash because this drawdown may last longer than anticipated is not the way to go.
A detailed financial plan will take into consideration just this – worst nightmares – high inflation, sustained bear markets, the chance of overspending. I wouldn’t suggest finding out what staying in cash throughout your entire retirement would do to your success rate, but check it out if you must to see the real consequences.
At this point, you should ask yourself, what kind of bike do you want to be on? An eleven-chainring mountain bike, built to handle just about any terrain, or one that doesn’t go anywhere?
With the current environment, you’re probably best off with the former because we won’t always be able to unlax downhill without peddling. We don’t know what’s around the next bend, but if our bike is ready, we’re wearing a helmet, and we know that we can switch gears with ease, then get back to a comfortable pace.
Here’s a great read on how inflation affects you based on your stage in life.