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Mounting Costs

Sanjib Saha

INFLATION CROPS UP in almost every conversation I have with friends and acquaintances. Everyone’s getting squeezed by higher prices. Folks complain not only about where prices are today, but also about how quickly they rose.

Prices today seem shocking compared to last year or the year before that. But how do they compare to prices from 10 years ago? To find out, I calculated the average annual inflation rate over trailing 10-year periods using the Consumer Price Index for All Urban Consumers (CPI-U). The chart below shows the rolling 10-year average annual inflation rate for the past 80 years.

Lately, 12-month CPI-U has been running around 9%. But if we extend the time horizon back 10 years, to mid-2012, the recent spike barely registers, with the average annual increase for the past decade coming in at just 2.6%. From this longer-term perspective, inflation looks deceptively mild.

Going back 10 more years, the average annual price increase for the 10 years through mid-2012 was 2.5%, almost identical to the most recent 10-year stretch. Does anyone remember a ruckus being made about price increases in 2012 similar to the one being raised today?

 My point: A sudden surge in inflation causes panic, but the insidious effect of slow and steady inflation gets little attention. When I pointed this out to a friend, he wasn’t impressed. It seems he would’ve preferred steady, annual price increases of 2.6%, instead of the low inflation we’ve enjoyed for much of the past decade followed by a sudden spike.

I wasn’t so sure. Why not? Let’s assume my friend’s annual spending as of mid-2012 was $10,000 a year and his yearly expenses went up in lockstep with CPI-U. His total expenses from July 2012 to June 2022 would amount to $110,267. But if, instead, he got his wish of steady 2.6% annual inflation starting from 2012, his spending over the 10 years would have been $115,405—almost 5% more.

Why the difference? Remember, each year’s inflation builds on past price increases, so—if you must have inflation—it’s less damage if you have low inflation early on and higher inflation later.

For proof, let’s run history backward. I’ve taken the actual inflation numbers from the past 10 years but reversed their order, assuming that the annual inflation rate was 9.1% in 2013, 5.4% in 2014, 0.6% in 2015 and so on, ending at 1.8% in June 2022.

In this backward universe, my friend’s cumulative expenses for the 10 years would climb to $120,569. That’s 9% more than before. The reason: The inflation spike came at the start of the 10-year period rather than at the end.

This experiment demonstrates sequence-of-inflation risk. High inflation at the start of a period is more costly to us because higher prices stick around, even if inflation subsequently settles down. In other words, prices reach a permanently higher plateau after a spike and then continue climbing from there.

This sequence-of-inflation risk is particularly dangerous for folks who are in the early years of retirement or who are planning to retire shortly. The risk has similarities to sequence-of-return risk—the double-whammy of suffering investment losses early in retirement while also withdrawing from a portfolio—but it’s harder to counteract.

If the market drops in the initial years of retirement, retirees can dodge the bear market by living off their stable investments, instead of selling stocks at lower prices. No lasting harm is done to the retirement portfolio if we can weather the entire bear market—which might last several years—in this manner. When the market rebounds, the effect of the earlier price drop disappears as if nothing happened.

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Sadly, it’s not so simple with sequence-of-inflation risk. Retirees can’t simply stop spending when inflation runs high. Moreover, the elevated prices from a high inflationary period stick around even when inflation eventually tapers down. The result is significantly higher withdrawals over the course of retirement.

What, then, would be a good strategy to handle sequence-of-inflation risk? First, stocks are a great inflation hedge over the long run. Some experts suggest that, even in retirement, allocating a minimum 50% of total investable assets to stocks might work well to fight unexpected inflation.

Second, for cash and bond investments, there are Treasury Inflation-Protected Securities, or TIPS, but they come with a catch. When we buy TIPS, the expected inflation rate is already priced in. That means we’re insured against additional unexpected inflation from there. But it might be too late to invest in TIPS if the breakeven inflation rate—the difference in yields between a regular Treasury bond and its inflation-protected counterpart—is already high. If inflation turns down over the holding period, the high price paid for the inflation protection would be wasted.

The breakeven inflation rate for both five-year and 10-year Treasurys spiked above 3% in recent months, but has come down since. As we’ve seen, that peak is a bit higher than the long-term inflation rate in recent decades.

Most of my non-stock investments are in a short-duration TIPS fund, but I’m thinking of replacing it with a ladder of individual TIPS bonds, each maturing in a different year. Inflation’s bite on my finances will eventually weaken once I start receiving Social Security benefits, with their annual inflation adjustment. But until then, my TIPS ladder should provide some relief.

Sanjib Saha is a software engineer by profession, but he’s now transitioning to early retirement. Self-taught in investments, he passed the Series 65 licensing exam as a non-industry candidate. Sanjib is passionate about raising financial literacy and enjoys helping others with their finances. Check out his earlier articles.

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Steve Spinella
Steve Spinella
1 month ago

I love it. In other words, while bonds might protect us against losses in the stock market, stocks might protect us from inflation. It helps me understand why I haven’t been swayed by arguments about holding money in bonds for safety–I’m a lot more worried about inflation than I am about market corrections.

Kevin Knox
Kevin Knox
1 month ago

Thanks for the thoughtful article.

A couple of additional points: TIPS are a much better deal than iBonds at the moment, with the most recent 10 year issue offering a .63% coupon rate (vs. zero for iBonds) and of course no purchase limit. The well-known TipsWatch site is invaluable for tracking all of these inflation-protected options.

William Bernstein and others have pointed out that while stocks may outpace inflation over long time periods only TIPS do so reliably. That’s why liability-matching portfolios like those he and DFA recommends for retirees include enough TIPS to generate income to cover all of a retiree’s essential expenses.

Last but not least, for retirees anyway there’s just no compelling reason to choose nominal bonds over TIPS. Fantastic thread about his over on the Bogleheads forums. It would take hours to read all of the posts (time well spent for some of us, not so much for others) but the first post lays out the case compellingly, IMHO:

https://www.bogleheads.org/forum/viewtopic.php?t=382830

Michael1
Michael1
1 month ago

Great article and Sanjib. There’s not much out there about sequence of inflation.

On I-bonds, while they’re close to a no brainer for near and early retirees, I’m wondering about their usefulness for late retirees, given the five year wait to use the money without a penalty.

(I realize even withdrawing with a penalty beats a CD, though also more hassle.)

Last edited 1 month ago by Michael1
Sanjib Saha
Sanjib Saha
1 month ago
Reply to  Michael1

Thanks, Michael. Given the certainty and safety, I think I bonds are worth the risk of early withdrawal penalties, as long as the money isn’t needed within a year of purchase.

Brent Wilson
Brent Wilson
1 month ago

Great article and appreciate the comparison of sequence of return and sequence of inflation risk.

I would also mention Series I Savings Bonds as a great inflation hedge. Purchase limitations aside, I feel like it’s a no brainer to build up a war chest of these as they are essentially risk free and guarantee your cash investments keep up with inflation.

Sanjib Saha
Sanjib Saha
1 month ago
Reply to  Brent Wilson

Thanks, Brent. Yes, the Series I Savings Bonds is even better than TIPS, because there’s no pricing in of the expected inflation other than the real interest rate component of it. The annual purchase limit makes it a bit challenging to use it for large amounts.

wtfwjtd
wtfwjtd
1 month ago

Great discussion of an often-neglected topic. While a portfolio heavy in stocks should weather inflation better over the long haul, a diversified portfolio can often do better in shorter-term time periods of higher inflation. This discussion just emphasizes yet another reason that diversification is a smart idea.

Sanjib Saha
Sanjib Saha
1 month ago
Reply to  wtfwjtd

Thanks for your note. I agree that Portfolio Diversification to handle unexpected inflation is a must-have.

David Powell
David Powell
1 month ago

Retiring into unusually high inflation and twin market corrections, in bonds and equities, would stress even the most solid financial plan. Imagine the greater peace of mind from continuing just a bit longer to the other side of that.
😉

Sanjib Saha
Sanjib Saha
1 month ago
Reply to  David Powell

🙂
Thank you, David.

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