As financial advisers, clients often come to us with various questions about GDP, unemployment, interest rates, consumer consumption, and how these numbers can affect the market and their investments. I like to be prepared and have the current figures ready for my clients as well as the context to help answer their questions.
Lately, clients have noticed the rising costs across many of their expenses: groceries and rent to name a couple. Naturally, they may be frustrated and turn to us to help them understand what’s going on. Why is everything more expensive? What’s causing record-high inflation? How do the US Federal Reserve’s interest rate hikes help address this?
Such discussions require that we have more than a quick stat or two at the ready. There is a lot of context we may need to fill in to help explain the current situation. We might have to sit down and explain the many in-between correlations, relationships, and effects of rising prices. What is really happening in the economy right now? How will central banks try to solve it? Can they?
Here are a few tips to approach these conversations with clients:
1. Define Inflation
First off, it may help to explain to clients what inflation is and why it matters in the long term. Put simply, inflation is the increase in the prices of goods and services. Deflation, on the other hand, is when these prices decline over time. So inflation raises the cost of living in an economy. This means that, over time, it takes more money to buy the same items and the consumer’s purchasing power declines.
To be sure, consistent, incremental inflation is necessary for a healthy economy. If inflation is too low, that indicates a low demand for goods and services and can lead to a potential economic slowdown. However, inflation also becomes a problem when it is too high. Left unchecked, sustained high inflation can slow the economy and erode savings. This is why we need to work closely with our clients to help them find ways to sustain 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 principal barometer of US inflation. The CPI stayed mostly flat in July versus June after gas prices declined for 57 straight days. But year-over-year, prices are up 8.5%. Food prices have been a key culprit: They are up almost 11% over last year. That poses a burden to many families.
So, clients may ask, how did we even get to this point?
Causes for inflation vary, but they tend to be products of the economic principles of supply and demand. While there are other variations, economists typically categorize inflation into two core concepts:
- Demand-pull: The demand for goods and services increases, but the supply does not keep pace.
- Cost-push: The supply of goods and services falls, but the demand for them does not.
Today’s persistent inflation has no one single cause. Rather, multiple factors in the global economy contribute to it. According to research from the Federal Reserve Bank of San Francisco, supply factors are responsible for about half of the recent rise in inflation. So, what does that mean?
Supply-chain issues 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 US government stimulus propelled a robust recovery from the pandemic-fueled economic crisis and, in turn, increased both income and demand. Record low US unemployment and a tight labor market brought on wage growth. Then, the Russia-Ukraine war reduced the global 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 to lowering inflation? The Fed has a dual mandate to promote maximum employment and stable prices. If it seems like inflation is driving up prices too quickly, the Fed will raise interest rates to try and contain it by increasing the cost of borrowing (e.g. 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 spur economic activity. For example, in 2008, the discount rate was set to zero. We were in a financial crisis — a really bad one. To stimulate consumer consumption and inject liquidity into the economy, the Fed lowered rates so people would borrow to buy goods and services, start businesses or increase inventories. This is how it works in theory: More consumption leads to more spending, which leads to more growth, more people to hire, more paychecks cashed, and, again, more consumption.
Today, by raising interest rates, the Fed wants to increase the cost of credit. That tends to make people less willing to borrow and, in turn, less willing to spend. For example, a client may decide to buy a new house 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 and more limited money supply. Consumers will therefore spend less. Higher rates can “cool off” the economic landscape. To go back to basic economic theory: less demand means lower prices.
4. Help Clients Manage the Impact
Everyone has different circumstances, priorities, and long-horizon goals. This is 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 expenses, but it also has implications on long-term planning. This is why we need to periodically review their allocations with them.
Clients may ask if they should adjust their portfolio right now. And the truth is there isn’t one “right” answer for everyone. Inflation affects every 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 headed.
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 advisers, when there’s uncertainty and certainly this year is providing plenty of that.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
J.P. Morgan Wealth Management is a business of JPMorgan Chase & Co., which offers investment products and services through J.P. Morgan Securities LLC (JPMS), a registered broker-dealer and investment advisor, 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 custody and other services are provided by JPMorgan Chase Bank, N.A. (JPMCB). JPMS, CIA and JPMCB are affiliated companies under the common control of JPMorgan Chase & Co. Products not available in all states.
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