We have many reasons to believe that U.S. inflation will remain high for several years to come, and that stocks may be your best option for long-term savings.
In the 1990s and 2000s, the average annual increase in the consumer price index was about 2%. Americans benefited from the digital revolution. Major improvements in computing power and easier access to software via the Internet, the cloud and smartphones have increased productivity.
Meanwhile, globalization and economic reform brought China and smaller Asian economies into the West’s supply chain: cheap labor for cheap coffee tables and computers. Unemployment in the West was a chronic policy problem, but that kept wages and inflation low, even in non-traded services.
Now that has all been reversed. Artificial intelligence is replacing the internet as an engine of change, but ChatGPT brings very different challenges. AI is tasked with replacing workers with complex skills and judgment, and that will prove more difficult.
Declining birth rates and partisan feuds over immigration reform have led to skilled labor shortages. Expensive college degrees often don’t translate into marketable skills. All this creates wage pressure – and inflation.
Economic reforms made China prosperous but also dangerous for the world order. Moving production to Vietnam, India, Mexico and other countries and relocating semiconductor production is costly and inflationary.
Meeting competing demands for stronger military and social programs is driving up America’s federal deficits. These will force the Federal Reserve to choose between uncomfortably high interest rates or printing money to buy the resulting debt.
Inflation in the US is likely to be between 3% and 4% rather than 2%. As base inflation rises, so does volatility: spikes to 5% or 7% are more painful for consumers than spikes to 3%
All of this is tough on America’s aging population. For example, teacher pensions in Virginia are adjusted for inflation by up to 3% annually. Above that, retirees hired before 2010 will receive half that rate, up to 5%. Those hired later will receive a maximum of 3%. Many other defined benefit pensions pose similar problems, as do many annuities.
Most Americans do not receive defined benefits. They plan for retirement using tax-deferred accounts opened by employers, or save through IRAs and similar vehicles. Historically, people were advised to invest in stocks according to the ‘100 minus your age’ rule. For example, if you are 65, that is 35% stocks and 65% bonds.
Still, a spike in inflation and interest rates reduces the purchasing power of payments from existing bonds and the market value of those bonds for retirees who are gradually selling securities.
Higher inflation forces Americans to take more risk by investing larger shares in stocks, such as an S&P 500 SPX index fund. According to a database from the NYU Stern School of Business, the average annualized return of the S&P 500 over the past 25 years was 9.2%, while 10-year Treasury bonds yielded 1.8% and home values increased 5.3%.
If you can own a house for about as much as you can rent, buy only as much house as you reasonably need. Otherwise, the money would be better invested in shares. After all, you cannot sell the bedrooms abandoned by adult children one by one because you need cash. Downsizing real estate is expensive: you will have to deal with real estate agent costs, renovating the new house, moving costs and renting storage space, among other things.
Bonds and other fixed-income instruments such as annuities provide ballast, but at the expense of purchasing power. Over twenty years in retirement, the loss of 2% per year to inflation reduces the redemption value of a bond by 33%, and with 3% inflation the hit is 45%.
The safest route seems to be to invest mainly in shares and then gradually reduce your shareholding to 50% over the ten years leading up to your retirement. The more you save for retirement, the easier it will be to weather the stock market’s volatility. If you retire with half your wealth in stocks and half in 10-year government bonds, historical averages indicate an average annual return of about 5.5%. That should beat inflation.
Peter Morici is an economist and professor emeritus of business administration at the University of Maryland, and a national columnist.
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