The Effects of Inflation and How to Prepare for It

Extreme Inflation

An example of extreme inflation.

How will you cope when your expense budget goes up by 20% in the space of a few months?

Think this is just one of those scare tactic posts? Think again.

Thursday the 13th changed things for all of us.

If you need to be convinced that recent actions by the Federal Reserve have put the country on a collision course with inflation, read these to see why others think they did:

If you can see the danger of inflation already, read on.

The good news is we’re not talking about a total meltdown like the famous German hyperinflation of almost 100 years ago. It’s much more likely that we’ll repeat the experience of the 1970s, something called stagflation of the 1970s, which was kicked off by shortages and prices shocks, somewhat like the drought of 2012. (You can Google “stagflation” if you feel you want to learn more about it.)

Chances are you are more financially savvy than the general population, which means you know what your monthly expenses are. If you pay rent or have an adjustable mortgage, add up all your expenses and add 20% to it. What’s the new total? Are you still good? Add another 15% for next year. Where are you?

If you’re barely making it now, this is your alarm bell. If history is any guide, your income may eventually catch up, but your expenses will rise before it can. And you’re always behind. Just when you get your 10% raise, your expenses go up by 12% before you can even call your friends to celebrate. Oh, and speaking of calling, those calls will be more expensive, too.

When prices go up all around us, people live in fear of the next expense that’s going to go up, stressed that their income is not keeping pace with inflation. Especially in our current economy with high unemployment and underemployment, where people are taking lower paying jobs just to have an income.

So What Do You Do About It?

The general strategy is you make your income changeable and your expenses fixed. With inflation, everything that can go up will. That’s good for income, not for expenses. So, what to do?

A. Income — Let it Float

1. Wage Income

In today’s economy employees have little leverage when it comes to negotiating raises. In an inflationary economy it gets worse. Your employer has to pass on cost increases, but will have a hard time doing that because its customers will scream and fight back. In that environment, businesses compete to see who has the smallest cost increases. And most companies’ largest cost item is salaries and wages.

In other words, if you think you have a hostile environment when it comes to your wage income, and raises, to quote the BTO song: You ain’t seen nothin’ yet.

Your best strategy is to become more valuable as an employee to put you in the best position to be first in line for raises. This is a topic all on its own, and this post on asking about layoffs during the interview offers a starting point.

2. Side Hustle

If there’s any skill you have, now is a good time to dust it off and begin establishing it as a side business. Your opportunity for an extra income needs to be securely established when the cost of food doubles. Doing taxes, painting houses, fixing cars, hey, even blogging, these are all things people do for extra income. What is yours? If you don’t know where to get started, there are resources out there to help you out in making extra money.

3. Investments

Your Home – The first investment is your own home. There are some who argue that renting a home can be preferable to owning. In times of inflation, though, rents escalate. The key strategy for inflation is: buy your own home and finance it ONLY with a fixed rate mortgage. Its value will go up (see the 70s median home prices here) but your payment will stay the same.

Rentals – The beauty of a rental is you can raise rents legitimately against the backdrop of general inflation. And if your mortgage payment is fixed, you have probably the best inflation proof investment of all.

Gold – I’ve never been an avid proponent of investing in precious metals, but this gold prices chart shows that an inflationary environment is where gold shines.

Stocks – Stocks (and by extension mutual funds) do not have a great track record (as seen by this S&P 500 chart) through the 1970s as a stagflation proof investment. Companies are whipsawed between rising costs and their ability to raise prices. This is where investing in individual stocks will outperform mutual funds, but only if you focus on companies with pricing power, like UPS and Fedex, who can raise their rates at a moment’s notice.

Bonds – Bonds are an iffy investment in times of inflation, because once public pressure forces the Fed to raise interest rates, bond values will actually drop.

Savings – And of course, money market funds, savings accounts or CDs are probably the worst investments in times of inflation, as those interest rates will usually trail the inflation rate.

Expenses — Tie Them Down

Housing – The best way to keep your housing costs fixed is to buy a place of your own, either for cash or with a fixed rate mortgage. Renting may be a viable option in a time of low inflation, but with inflation you can expect your rent to go up. If you have no choice, then you might want to pursue the longest possible lease term, because the rent escalation in it might be less than the inflation rate.

Transportation – A used car makes more financial sense than a new car most of the time. Inflation might be the only exception, and here’s why: if you buy a reliable new car, you can make it last ten years or more. If you can’t pay cash, then make sure the financing contract has a fixed interest rate. Once the car is paid off, you can keep going and bypass the rising cost of new and used cars.

Debt – With the Fed making money so rampantly available, expect a gazillion offers for credit cards, auto loans, equity lines and mortgages stuffing your mailbox. Stay away from them all, because they likely will all have variable interest rates. In times of inflation, the Fed ALWAYS tries to stop it with higher interest rates.

Speculation – When prices go up, there’s something in the human brain that becomes unhinged. Everyone and his dog wants to “get in on a good thing.” It can be beanie babies, art, classic cars or houses. These are also called bubbles. This just in: not a single bubble has survived. They all crash, and they burn everyone in them. Hold on to what you have and try to get as out of debt as much you can.

End Game

The heavy inflation of the 1970s ended spectacularly with the biggest recession since the Great Depression. It’s the only way known to man to crush inflation.

Your biggest protection is just knowing it’s coming. Hurricane warnings can’t make it go away, but they can severely limits its damage.

If you protect your income (by being the best employee or business and knowing where to invest), keep your expenses low and get out of debt, you’ll escape the worst devastation. As Sandra Bullock said to the high school coach in The Blind Side: you can thank me later.

William Cowie is a retired businessman who survived the stagflation of the 1970s. Get his free tips on letting the economy work for you at www.dropdeadmoney.com.

Image by Peat Bakke

Last Edited: March 28, 2013 @ 12:47 amThe content of ptmoney.com is for general information purposes only and does not constitute professional advice. Visitors to ptmoney.com should not act upon the content or information without first seeking appropriate professional advice. In accordance with the latest FTC guidelines, we declare that we have a financial relationship with every company mentioned on this site.

Comments

  1. Cut down on “extra” expenses.  Entertainment for example.

  2. The economy says: Here comes your medicine and it’s going to hurt. . .
     
    We still aren’t out of this recession, and I agree that we may very well see stagflation. I have seen our grocery costs already take a big leap-about 20%. Fortunately, we run a budget and have dumped all of our debt-thank you Dave Ramsey-so we are not being squeezed as tightly as so many others.
     
    This is an issue, and it is on the horizon coming our way. You can prepare-great suggestions, William-or you can find yourself very possibly the out in the cold like the grasshopper from Aesop’s cautionary tale.

  3. deonnekahler says:

    William,
     
    Great post! Housing is the one thing I’ve got right, and the rest of my portfolio is tied up in stocks (mostly index funds). They’ve been doing well this year, and I have no need to sell any time soon (as in, it could be decades before i need that money), so I should be fine. Right? Right??? (ha)
     
    Thanks, as always, for the useful info.
     
    Deonne

  4. Increasing inflation is a one the biggest challenges for an average person who always been advised to save money rather than investing it somehow.
     
    Only one way to beat the inflation is through investing…. investing… investing….
     
    According to me rental properties and stocks can be great options for the investors who want to protect themselves against inflation.

  5. I see the price of rental homes is definitely going up. It is an ideal time to invest in real estate for those with disposable income. It is also not a time to go for credit offers as all the ones I see have high or variable interest rates.

  6. TheQuarterRoll says:

    @ptmoney Insightful article. Good idea about side hustle. Especially if you can turn it into tax deductions

  7. DropDeadMoney says:

    @ptmoney thx for the opportunity! Sorry ’bout the Saints for you.

  8. stagflation or inflation either way kind of nasty.  The post mentions that the stock market (equity based investments) are not the best.  I may have to disagree with this one.  Given the rise of ETFs as an investment tool, a small group of ETFs may act as a hedge if and (let’s be honest) when inflation begins to hit the economy.  These are inverted bond ETFs, so they track the interest rate side of the bond, not the price which is common with almost all bond related investments including mutual funds.  Everyone should know the inverse correlation between a bonds price and yield (real interest rate). As one goes up the other goes down.  The ones I like to use or TBT and TMV from the Direxion and Proshares family.  They are leveraged so proceed with extreme caution.  However, if you pull up a chart of the ETF and compare it with the $TNX (10 year treasury index) or the $TYX (30 year treasury index) the correlation is pretty clear.  As interest rates rise so do they.  As interest rates fall, they fall too.  I talk about the market through the eyes of technical analysis on my blog: everyinvestor.blogspot.com