As financial advisors, clients often come to us with various questions about GDP, unemployment, interest rates, consumer consumption and how these numbers may affect the market and their investments. I like to be prepared and have the current numbers ready for my clients as well as the context to help answer their questions.
Lately, customers have noticed rising costs in many of their expenses: groceries and rent, to name a few. Naturally, they may get frustrated and turn to us for help figuring out what’s going on. Why is everything more expensive? What causes record inflation? How do US Federal Reserve interest rate hikes help solve this problem?
Such discussions require that we have more than a quick stat or two at our fingertips. There’s a lot of context we may need to fill in to help explain the current situation. We may have to sit down and explain the many correlations, relationships, and intermediary effects of rising prices. What’s really going on in the economy right now? How will central banks try to solve it? Can they?
Here are some tips for approaching these conversations with customers:
1. Define inflation
First, it can be helpful to explain to clients what inflation is and why it matters over the long term. Simply put, inflation is the increase in the prices of goods and services. Deflation, on the other hand, occurs when these prices decline over time. Thus, inflation increases the cost of living in an economy. This means that over time more money is needed to buy the same items and the purchasing power of the consumer decreases.
Certainly, constant and progressive inflation is necessary for a healthy economy. If inflation is too low, it indicates weak demand for goods and services and can lead to a potential economic downturn. However, inflation also becomes a problem when it is too high. If left unchecked, high and sustained inflation can slow the economy and erode savings. That’s why we need to work closely with our customers to help them find ways to maintain their buying power over time.
2. Explain how we got here
The Consumer Price Index (CPI), published monthly by the Bureau of Labor Statistics, is the main barometer of inflation in the United States. The CPI was essentially flat in July compared to June after gasoline prices fell for 57 straight days. But year-over-year, prices were up 8.5%. Food prices were one of the main culprits: they rose almost 11% compared to last year. This represents a burden for many families.
So customers may ask, how did we get to this point?
The causes of inflation vary, but they tend to result from the economic principles of supply and demand. Although there are other variations, economists generally classify inflation into two basic concepts:
- Call on request: The demand for goods and services increases, but the supply does not follow.
- Cost increase: The supply of goods and services decreases, but not the demand.
Today’s persistent inflation does not have a single cause. On the contrary, multiple factors in the global economy contribute to it. According to a study by the Federal Reserve Bank of San Francisco, supply factors are responsible for about half of the recent rise in inflation. So what does this mean?
Supply chain issues have created a shortage of goods and materials. This was exacerbated when many factories temporarily halted production in China due to the country’s zero COVID policy. Meanwhile, trillions of dollars in stimulus from the US government propelled a robust recovery from the pandemic-fueled economic crisis and, in turn, boosted both income and demand. A record unemployment rate in the United States and a tight labor market have led to wage growth. Then the Russian-Ukrainian war reduced the world supply of oil, wheat and other raw materials.
3. Explain what the Fed rate hikes have to do with it
Why and how are interest rate increases correlated with falling inflation? The Fed has a dual mandate to promote maximum employment and stable prices. If it looks like inflation is driving prices up too quickly, the Fed will raise interest rates in an attempt to contain it by increasing the cost of borrowing (eg credit cards, mortgages, etc.). This in turn reduces demand, which could lead to lower prices.
But the Fed will also cut rates when it wants to stimulate economic activity. For example, in 2008 the discount rate was set to zero. We were in a financial crisis – a very bad one. To stimulate consumer consumption and inject cash into the economy, the Fed lowered rates so people would borrow to buy goods and services, start businesses or increase inventory. Here’s how it works in theory: More consumption leads to more spending, which leads to more growth, more people to hire, more paychecks taken, and, again, more consumption.
Today, by raising interest rates, the Fed wants to increase the cost of credit. This tends to make people less willing to borrow and, therefore, less willing to spend. For example, a customer may decide to buy a new home with a 3% mortgage, but a 5% mortgage may push it out of their price range. As interest rates on savings accounts rise, more people may be encouraged to put their money in the bank.
The thought process goes something like this: higher rates mean a tighter, more constrained money supply. Consumers will therefore spend less. Higher rates can “refresh” the economic landscape. Going back to basic economic theory: less demand means lower prices.
4. Help customers manage the impact
Everyone has different circumstances, priorities and long-term goals. That’s why it’s important for our clients to have a long-term financial strategy that aligns with their personal goals. Inflation can affect day-to-day spending, but it also has implications for long-term planning. This is why we must periodically review their allocations with them.
Clients can ask if they should adjust their portfolio now. And the truth is, there isn’t a “right” answer for everyone. Inflation affects each sector differently. We need to talk to our clients and take a comprehensive look at their entire financial outlook, and discuss where each asset class is heading.
What we do know is that diversified portfolios tend to perform the best over time, regardless of the inflationary environment. We also know that clients need us, their advisors, when there is uncertainty and this year certainly offers a lot of that.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
JP Morgan Wealth Management is a business of JPMorgan Chase & Co., which offers investment products and services through JP Morgan Securities LLC (JPMS), a registered broker and investment adviser, member FINRA and SIPC. Annuities are made available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida. Certain custodial and other services are provided by JPMorgan Chase Bank, NA (JPMCB). JPMS, CIA and JPMCB are affiliated companies under the common control of JPMorgan Chase & Co. Products are not available in all states.
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