This article was last updated on May 3
There is an important debate brewing among economists today about inflation. On the one hand, many believe we are headed to double-digit inflation in the near term. Increased government spending coupled with a huge money supply thanks to the Fed’s liberal approach to printing money for all the recent stimulus programs, has led many to conclude that raising inflation is inevitable.
On the other hand, some economists believe that our massive debt will not lead to higher inflation (and may in fact cause deflation). They argue that rising personal debt and unemployment will keep people from buying, which in turn will keep prices in check. Alan S. Blinder, a professor of economics and public affairs at Princeton and former vice chairman of the Federal Reserve, also sides with those not concerned with inflation.
Ultimately, whether we see inflation as a significant risk is a decision we each must make for ourselves. But it should not be ignored, because our longer term net worth and retirement plans could be adversely impacted. If inflation is on the horizon, there are several steps we can and should take to prepare our finances for the rising tide of prices.
1. Refinance adjustable rate mortgages
Perhaps the most important step to take in preparing for a possible rise in prices (inflation) is to convert an adjustable rate mortgage to a fixed rate mortgage. With rising inflation comes rising interest rates. Why? The Federal reserve uses monetary policy (i.e. control of interest rates) to combat inflation. To lower inflation, they try and make “money” more expensive by raising the prime rate. This causes all other rates, like those on home and auto loan rates to rise as well.
For most of us, our mortgage is far and away the largest monthly bill, and we cannot afford to risk seeing our payments go up by hundreds of dollars a month as adjustable interest rates rise. The first step in refinancing an adjustable rate mortgage is to go online and find a better rate from the many lenders out there. Depending on where you live, refinancing through your existing mortgage company can save you on fees and taxes. If you have a home equity line of credit with the same mortgage company, it also will be easier to get the line “resubordinated.” Resubordination is just the industry’s term for making sure the line of credit stands behind the primary mortgage in a foreclosure. In addition, you may get a slightly better deal with your existing mortgage company, but of course always get several interest rate quotes before making a decision.
2. Convert home equity lines to loans
Most home equity lines of credit are variable rate and require interest only payments for the first ten years. Thereafter, the line converts to a loan that amortizes over the remaining 20 years of the note. Right now, many home equity lines of credit have very low interest rates because the prime rate is so low. Our home equity line of credit is currently 3.99%, and that’s before taking into account the tax deduction we get on our interest payments.
But these great rates may not last. If the Fed is forced to raise rates to combat inflation, the prime rate will go up and the rates on home equity lines will follow suit. In a serious bout of inflation, rates on equity lines could easily hit double-digits (like in the early 90’s). One way to address this risk is to convert some or all of a home equity line balance to a fixed rate home equity loan. The interest rate will most likely be higher than the current variable rates on most lines, but it will be fixed for the remainder of the loan and you won’t have to worry about rising payments.
3. Pay off introductory rate credit cards
I’m a big fan of 0% balance transfer offers and other no interest deals. We’ve taken advantage of them to reduce interest payments and speed up our debt repayment plan. The risk of these deals, however, is that you don’t pay off the balance before the introductory rate expires. Once the introductory rate expires, the regular APR for the card applies, which is typically 10% or higher.
As early as last year, one could jump from card to card taking advantage of balance transfers, often with no transfer fee. Today, however, these offers have become more scarce and increasingly available only to those with very good credit scores. The point is that we shouldn’t be relying on balance transfer cards to keep our debt at a low rate. And if interest rates in general go up, they will certainly go up on credit cards. As a result, while we continue to take advantage of no interest deals when they make sense, we have redoubled our efforts at paying down our debt, even the debt on 0% deals.
4. Shy away from long term CDs
Certificates of deposit (CDs) offer a secure way to put away cash for an emergency fund or other short term savings goals. When picking a CD you have a choice in the term, generally ranging from three months to five years. As a general rule, the longer the term, the higher the interest rate, although this isn’t always true.
For those worried about inflation, however, locking your money away for five years at 3.45% could turn out to be a big mistake. A 1-year CD from Ally currently pays 2.30% APY, and presents far less interest rate risk than a 5-year CD. You can always withdraw money from a CD, of course, but you’ll often pay a penalty fee. At Ally, the penalty fee for early withdrawal on a 5-year CD is interest equal to six months. For this reason, for those fearing inflation, 1-year CDs or shorter term is probably best.
Another great alternative to a CD is an online high yield savings account. While interest rates have come down significantly over the past 12 months, rates are still competitive with most CDs and the money can be withdrawn on demand and easily managed online.
5. Consider TIPs, Real Estate and Commodities
I don’t believe in making dramatic changes to an asset allocation plan based on current market fluctuations. We haven’t sold any of our investments during the brutal market we’ve experienced over the past year, and the same will be true if inflation starts to bubble up.
Yet there are some modest changes one can make to better guard their portfolio against the ravages of inflation. Specifically, one can look at investing in TIPs, REITs, and commodity funds. Here they are in a nutshell, and how they can help guard against inflation:
TIPs or Treasury Inflation Protected Securities, are U.S. Treasuries whose interest rates rise and fall with the Consumer Price Index. While some debate the accuracy of the CPI, it is a recognized measure of inflation in the United States. As the CPI rises, so do returns on TIPs. And as a result, TIPs provide some measure of protection against inflation.
REITs: Over the long run, real estate values tend to follow inflation. In the short term, higher inflation can actually depress real estate values because higher interest rates keep many buyers at home. Many REITs (Real Estate Investment Trusts), of course, invest in commercial real estate, however, which is an entirely different market. With inflation comes higher rents, and thus higher returns and valuations on REITs that invest in commercial property.
Commodity Funds: These funds invest in precious metals, food commodities like grain, and oil. Commodity prices can fluctuate widely (just think of oil last year) for a variety of reasons, but do have a strong correlation with inflation, making them worth considering as a viable hedging option.
In the final analysis, nobody knows what inflation will look like a year from now. But guarding against the risk of inflation, at least in some of the above areas, may just help you sleep better at night.