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| The Basics | Lessons from the days of 13% inflation
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As inflation returns to life, lets recall some hard truths: Now is cheaper than later. Fixed interest is better than variable. And dont bail on stocks and bonds.
By Liz Pulliam Weston
If you have ever lived in an era of real inflation, you understand why economists are so paranoid about even the slightest hint of accelerating prices.
But more than half the U.S. population is under 40, which means they either weren't born yet or were still minors the last time the country experienced double-digit inflation rates.
Here's just a sample of what life was like then:
- Prices increased 40% in just three years, from 1979 to 1981. Every trip to the grocery store, it seemed, resulted in a bigger bill.
- The prime rate, currently 6.75%, peaked at 21.5% in December 1980. Borrowing became prohibitively expensive as the Fed tried to break inflation's back.
- Fixed-rate mortgages, currently hovering around 6%, averaged 17.5% in 1982. That means the payment on a $200,000 mortgage back then was $2,933 --compared to less than $1,200 at today's rates.
| What real inflation looks like | | Year | Annual inflation | Year | Annual inflation | | 1973 | 6.16% | 1979 | 11.22% | | 1974 | 11.03% | 1980 | 13.58% | | 1975 | 9.2% | 1981 | 10.35% | | 1976 | 5.75% | 1982 | 6.16% | | 1977 | 6.5% | 1983 | 3.22% | | 1978 | 7.62% | 1984 | 4.3% |
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Source: Bureau of Labor Statistics
By contrast, today's inflation rates still seem relatively tame: consumer prices are up 4.7% for the past 12 months, while wholesale prices are up 6.9%. But the trends economists see are ominous. In September alone, for example, consumer prices rose 1.2%, the biggest jump in 25 years. Wholesale prices rose at the fastest rate in 15 years.
Who hurts, who prospers
Since so many of us have never dealt with serious inflation, and the rest of us are out of practice, it's time to review the basics: who wins, who loses and how best to cope.
When inflation starts eroding the purchasing power of the dollar, the folks most at risk include:
- People on fixed incomes. Your Social Security and disability checks may have a cost-of-living increase built in, but those typically lag the actual inflation rate, which can spell some tight times. People living on income from CDs and other cash savings may see their yields climb, but again at less than the inflation rate. "The purchasing power of their principal will be eroded," said Ray Benton, a financial planner in Denver. "And rising interest rates generally do not keep up. Typically, real returns turn negative on fixed-income instruments."
- The poor. The less money you make, the more of your budget is spent on basics like food, shelter, clothing and transportation, and the less flexibility you have to deal with rising prices.
- Holders of long-term bonds. Rising rates drive down the value of older, lower-paying bonds. The longer the term of the bond, the bigger the hit it can take.
- People with variable-rate debt. Interest rates aren't fixed on most credit card and home-equity borrowing; many mortgages have adjustable rates as well. That means rising payments.
The winners? Folks with fixed-rate debt, which gets easier to repay with ever-cheaper dollars, and those who have investments that can beat the rate of inflation.
More from MSN Money and BusinessWeek
Your inflation game plan
So here are the lessons to be learned when dealing with inflation:
Don't rush to pay off your fixed-rate debt. Even at modest inflation rates, the payments on fixed-rate mortgages, auto loans and other debt get cheaper every year. If prices continue to accelerate, the mortgage payment that seems so monumental today will quickly start to feel like a bargain.
Push harder for that raise. Rising wages can accelerate the inflationary cycle: as workers demand more pay to cope with rising prices, employers boost prices even more to cope with the higher costs. But that doesn't mean you should take the fall. If you're going to cope with higher gas, heating and food costs, you're going to want more income.
Get ready to substitute. Prices for different goods and services rise at different rates, which means savvy shoppers have opportunities to substitute a relatively cheaper item for a more expensive one. Eggs, for example, rose nearly 50% after Hurricane Katrina devastated many of the nation's poultry producers; price-conscious consumers will be eating more oatmeal for breakfast. All the ways frugal folks have traditionally found to save money become even more helpful as prices soar.
Buy now, but don't charge it. Today's consumers are used to being rewarded for waiting. Delay buying that computer, for example, and you'll get a better, more powerful one for less next year.
In an inflationary environment, though, rising prices reward those who buy now rather than later.
"As a young man, I tried to buy things quickly before they went up in price -- a convenient excuse," mused Bob Rockwell, a financial planner with CCB Financial Services in Sandy, Ore.
Obviously, you'll want to keep living within your means, and you don't want to finance these purchases with variable-rate debt, like credit cards. But if it's a matter of buying now or buying later, the scales start to tip in favor of buying now.
Get real. Investments in so-called "real assets" -- real estate, natural resources and commodities -- can help you hedge against inflation. Mutual funds that specialize in natural-resource investments, for instance, rose 22% in the third quarter, compared to 4.7% for funds overall.
"If you invest in assets that are part of inflation," Rockwell said, "then they should inflate in value and offset much of the damage."
Stay invested in stocks. The slightest hint of accelerating inflation often sends the stock market into a tizzy, which has given some investors the mistaken notion that equities are a bad place to be in an inflationary environment.
In reality, stocks did pretty well during the country's last bout with significant inflation, posting double-digit returns in six out of the 10 years during the inflationary decade starting in 1974. Over the long haul, most investors need the inflation-beating returns stocks provide if they want to reach their retirement and other goals.
| Stocks vs. bonds, the inflation years | | Year | S&P 500 | Long-term Bonds | Year | S&P 500 | Long-term Bonds | | 1974 | -26.47 | 4.35 | 1979 | 18.44 | -1.23 | | 1975 | 37.2 | 9.2 | 1980 | 32.42 | -3.95 | | 1976 | 23.84 | 16.75 | 1981 | -4.91 | 1.86 | | 1977 | -7.18 | -0.69 | 1982 | 21.41 | 40.36 | | 1978 | 6.56 | -1.18 | 1983 | 22.51 | 0.65 |
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Source: Ibbotson Associates
Don't eschew bonds. Even though bonds tend to suffer when rates rise, they're still important to most people's portfolios. They can provide an important cushion against stock market volatility. And when they fall in value, they tend to fall far less than stocks.
Finally, remember that nothing is certain. This inflation scare could be just that: a scare.
"As long as the Fed continues to control the money supply, as indicated by short-term interest rates, inflation will not necessarily be the result," Benton said. "The system may self-adjust and (Federal Reserve chief Alan) Greenspan may be able to induce a final 'soft landing.' "
Those who have lived through inflation in the past certainly hope so.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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