As financial advisors, clients often come to us with various questions about GDP, unemployment, interest rates, consumer spending, and how these numbers can affect the market and their investments. I like to be prepared and have current numbers ready for my clients, as well as context to help answer their questions.
Lately, customers have noticed increased costs in many of their expenses: groceries and rent, to name a couple. Naturally, they can get frustrated and turn to us to help them understand what’s going on. Why is everything more expensive? What is causing record inflation? How are the US Federal Reserve’s interest rate hikes helping to fix this?
These discussions require us to have more than a quick statistic or two at the ready. We may need to fill in a lot of context to help explain the current situation. Perhaps we should sit down and explain the many correlations, relationships and intermediate effects of rising prices. What is really happening in the economy right now? How will central banks try to solve this? can they
Here are some tips for approaching these conversations with customers:
1. Define Inflation
First, it can help explain to clients what inflation is and why it matters in the long run. Simply put, inflation is the increase in the prices of goods and services. Deflation, on the other hand, is when these prices fall over time. Therefore, 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 consumer’s purchasing power decreases.
Undoubtedly, consistent incremental inflation is necessary for a healthy economy. If inflation is too low, this indicates low demand for goods and services and can lead to a possible economic slowdown. However, inflation also becomes a problem when it is too high. If left unchecked, sustained high inflation can slow the economy and erode savings. That’s why we work closely with our customers to help them find ways to maintain their purchasing 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 US inflation. The CPI was mostly flat in July from June after gas prices fell for 57 straight days. But year-on-year, prices are up 8.5%. Food prices have been one of the main culprits, rising almost 11% over last year. This is a burden for many families.
So customers may ask, how did we get to this point?
The causes of inflation vary, but they are usually products of the economic principles of supply and demand. Although there are other variations, economists usually classify inflation into two basic concepts:
- Demand attraction: Demand for goods and services is increasing, but supply is not keeping pace.
- Cost drive: The supply of goods and services falls, but the demand does not.
Today’s persistent inflation has no single cause. Rather, multiple factors in the global economy contribute. According to research by the Federal Reserve Bank of San Francisco, supply-side factors are responsible for about half of the recent rise in inflation. So what does this mean?
Supply chain problems created shortages of goods and materials. This was compounded when many factories temporarily halted production in China due to the country’s zero COVID policy. Meanwhile, trillions of dollars in US government stimulus fueled a strong recovery from the pandemic-fueled economic crisis, and in turn boosted both incomes and demand. Record U.S. unemployment and a tight labor market led to wage growth. Then the war between Russia and Ukraine reduced the world supply of oil, wheat and other commodities.
3. Explain what the Fed’s rate hikes have to do with this
Why and how do interest rate hikes correlate with lower inflation? The Fed has a dual mandate to promote maximum employment and stable prices. If inflation appears to be driving prices up too quickly, the Fed will raise interest rates to try to contain it by raising 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 lower 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, very bad. To stimulate consumer spending and inject liquidity into the economy, the Fed lowered rates so people could borrow to buy goods and services, start businesses, or build up inventories. Here’s how it works in theory: More consumption leads to more spending, which leads to more growth, more people to hire, more checks cashed, and more consumption again.
Today, with interest rates rising, the Fed wants to raise the cost of credit. This tends to make people less willing to borrow and, in turn, less willing to spend. For example, a customer may decide to buy a new home with a 3% mortgage, but a 5% mortgage may put them 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 and more limited money supply. Therefore, consumers will spend less. Higher rates can “cool” the economic picture. Back to basic economic theory: less demand means lower prices.
4. Help clients manage 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’s aligned with their personal goals. Inflation can affect day-to-day expenses, but it also has long-term planning implications. That is why we must periodically review their assignments with them.
Customers can ask if they need to adjust their portfolio right now. And the truth is, there is no “right” answer for everyone. Inflation affects each sector differently. We need to talk to our clients and take a comprehensive look at their complete financial outlook and discuss where each asset class is headed.
What we do know is that diversified portfolios tend to perform best over time, regardless of the inflationary environment. We also know that clients need us, their advisors, when there is uncertainty and this year is certainly providing plenty of that.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
JP Morgan Wealth Management is a JPMorgan Chase & Co. company, offering investment products and services JP Morgan Securities LLC (JPMS), a registered broker and investment advisor, member FINRA and SIPC. Annuities are available through Chase Insurance Agency, Inc. (CIA), a licensed insurance agency, doing business as Chase Insurance Agency Services, Inc. in Florida Some custody and other services are provided by JPMorgan Chase Bank, NA (JPMCB). JPMS, CIA and JPMCB are affiliated companies under common control of JPMorgan Chase & Co. Products not available in all states.
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