Inflation-proofing your life

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Life is lived in nominal dollars

I wrote last year about the fuzzy thinking I saw surrounding the topic of inflation. Inflation, properly understood, is an economy-wide increase in prices driven by too much money chasing too few goods, not when an early freeze destroys the Florida orange crop and raises the price of orange juice by 20 cents (drink apple juice instead!).

Inflation is a nightmare for creditors and a boon to debtors, which means under most circumstances, most people will benefit from a short period of high inflation; since inflation is economy-wide, their nominal incomes will rise alongside prices, but their nominal debts will remain fixed, making them easier to repay. Of course, over the long term interest rates will incorporate future inflation expectations and newly-issued debt will “catch up” to the lower value of the dollar going forward.

I am not, personally, at all concerned about inflation, but I read the same papers as everyone else so I understand some readers may be. And since I have this financial advice blog, I thought I’d share some ideas for inflation-proofing your life.

I want to stress these are not “lifestyle” recommendations; I’m not going to tell you to “cook more at home” or “buy store-brand cereal.” These are financial recommendations specifically aimed at dealing with any anxiety you feel about the possibility of an economy-wide increase in prices.

Housing

Housing is by far the largest expense in most people’s life (it’s essentially my only expense), and plays a huge role in federal inflation calculations. The feds calculate shelter price inflation in two distinct ways. First, they look at the actual change in prices actual renters pay to actual landlords (“rent of primary resident”). Then they ask homeowners how much they think their home would rent for (“owners’ equivalent rent”). The two values are then weighted and the total value of the shelter component of prices is calculated and added to the overall consumer price index.

This is, obviously, a bit absurd but it’s also true that if prices are rising economy-wide, that will eventually appear in actual rents and in owners’ equivalent rent.

Traditionally, long leases are preferred by landlords and short leases are preferred by tenants, because a short lease gives the tenant more flexibility to shop around for cheaper, more convenient, or higher quality units while a long lease guarantees the owner income and “traps” the tenant in the unit if they discover structural problems or pests. If you’re worried about inflation, the situation is reversed: a long lease with a fixed rent is an “asset” of the renter and a “liability” of the owner, forcing the owner to accept money worth less and less while the renter’s income rises alongside prices, mechanically making rent a smaller and smaller share of their income. That means one way a renter can inflation-proof their life is by asking to sign a two- or three-year lease instead of a one-year lease, or signing a one-year lease instead of renting month-to-month.

For homeowners with mortgage debt, the situation is simpler. Many homeowners choose to accelerate payments on their mortgages in order to own their home “free and clear” as soon as possible. If you’re worried about inflation, you’ll want to take the opposite approach: make only your minimum payment, and if possible refinance your remaining balance to a new, fixed-rate, 30-year mortgage. This will ensure that you’re repaying your creditor with the least-valuable dollars possible.

Energy

Food and energy are excluded from “core” inflation calculations because they’re a huge share of consumer spending but are so “volatile” changes in those prices would swamp the effects of price changes elsewhere in the economy: gas prices are such a high percentage of personal consumption that a 5% fall in the price of gas would make it appear prices were falling even if everything else cost 10% more (I’m making up these weights but that’s the general idea).

Nonetheless, if prices are rising economy-wide, that will eventually be felt in the price of energy as well. As I said up top, this is not a “lifestyle” post, so I’m not going to tell you to drive a more fuel efficient car or turn the thermostat down. But there are two obvious ways to combat energy inflation: reduce the amount you consume, or increase the amount you generate.

Renters are obviously in the worst position here, since they are typically forbidden from making structural improvements without the owner’s permission, but the situation isn’t hopeless. While landlords in my experience try to make the rental process seem as impersonal as possible, if you’re signing a new lease, you do have the option to negotiate, especially if your landlord knows you as a reliable tenant. Replacing old windows with new double- or triple-pane windows can lower your heating or cooling bill and improve your quality of life by improving the level of sound insulation, and give your landlord a new selling point when they look for a new tenant or sell the unit, creating the possibility of a win-win situation: offer to pay for the windows in exchange for a discount on rent. You get to enjoy the new windows, your landlord gets some light renovations, and you save on your energy bill. I just counted the windows in my apartment (10) and at a conservative $1,000 a pop that sounds ridiculously expensive, but if my landlord agreed to a discount on a 3-year lease would work out to just $277 a month. If I got a better price on the windows the discount would be even smaller, while the profit from reduced energy costs would go to us as long as we stay here.

The same logic applies to other energy-intensive appliances. Most new appliances are fairly energy-efficient, but if your unit has an old oven, microwave, refrigerator, or washing machine, it may be using more electricity than you think, and replacing it could save you real money.

For homeowners of course the same logic applies, but many times over: long-term financing of energy-saving equipment allows you to reap immediate savings of valuable 2022 dollars while repaying the debt with less-valuable dollars. The more worried about inflation you are, the more urgently you should try to reduce your nominal spending today and increase your nominal spending in the future.

But homeowners also have other options renters don’t, like installing rooftop solar or diversifying among energy sources. If your home is entirely electric, then installing a gas range or water heater is one way of spreading the risk of rising energy prices, since even under an economy-wide increase in prices, the price of individual energy sources is unlikely to rise by precisely the same amount so you can realize savings on one appliance even if another costs somewhat more.

The “risk” of rising interest rates

To combat rising prices, the Federal Reserve is widely expected to accelerate its already-planned interest rate hikes in 2022 and 2023. On the one hand, this makes little sense: if we are experiencing a shortage of cars, then increasing the interest car manufacturers have to pay on their debt would seem to make the shortage worse. If we’re experiencing a shortage of homes, then increasing the cost of financing home construction would seem to reduce the supply even further. Nevertheless, the Fed appears committed to this course, so all anyone can do is react to it.

Higher interest rates of course deter economic activity, but they also increase the amount of interest savers receive, so if you’re worried about inflation you should prepare yourself for the coming period of (relatively) higher interest rates. Existing long-term bonds will see their prices fall, while newly-issued debt will come with higher rates, so the most obvious step is to shorten your debt horizon. This need not (and should not) be done in a dramatic flurry of activity, but if you have an allocation to long-term investment-grade bonds in your portfolio, you might consider turning off dividend and capital gains reinvestment, or turn off automatic contributions to that fund.

Of course, you also need to do something with the resulting cash. My usual recommendations are for high-interest checking accounts but depending on how much money you have to allocate, you may exhaust the limits of the usual suspects. Vanguard’s VTSPX (or VTIP if you prefer ETF’s) offers short-term bonds with inflation protection and daily liquidity. There are medium-term options as well like the Series I Savings Bond deal I wrote about here.

And this is the through-line of all the strategies I’ve discussed so far: if you think we are currently in a low-interest, high-inflation environment, but heading into a high-interest, high-inflation environment, you want to “borrow long and lend short.” Lock in debt for as long as possible at today’s low nominal rates, then earn as much interest as possible over the rising interest rate cycle.

You can apply this logic in virtually any category of debt: federal student loan debt comes with long and favorable repayment terms, and low fixed interest rates. Mortgages and car notes are classic examples, but home renovations fall into the same bucket: borrow valuable dollars today, repay cheap dollars tomorrow.

Social Security is inflation-proof

Finally, if you’re worried about a period of high and rising prices, then the urgency is greater than ever to ensure that all of your earned income is properly reported to the Social Security Administration, since Social Security old age benefits are the surest protection from inflation.

That protection takes 3 forms:

1. wage inflation protection;
2. price inflation protection;
3. and early retirement protection.

I’ve written extensively about the first two already, so today I want to focus on the third. Claiming Social Security old age benefits prior to age 70 is considered by most financial advisors (and bloggers like me) to be a major error. But whether major or minor, it’s phenomenally common, and for obvious reasons: since most people save virtually nothing for old age, and most people loathe their jobs, most people claim their old age benefit the day they become eligible.

While protection from wage and price inflation is a major benefit of Social Security’s old age benefit, inflation comes with an accompanying risk: that interest rate hikes by the Federal Reserve will send the economy into recession, and folks who hoped or expected to work until their Social Security benefit is maximized at age 70 find themselves unemployed and unable to find new work that pays well enough to defer their old age benefit any longer.

The latest news hook for this is the pandemic, with older adults less willing to return to work in person or in unsafe conditions, but in that sense there’s nothing special about the 2020 recession. Regardless of the cause of an economic downturn, older adults are the first to leave the workforce and the last to return. Many of them never will, and for them, Social Security offers an essential lifeline.

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