Look out, inflation is coming!
Is your investment account ready?
This week, the minutes from the most recent Fed meeting were released and “almost all participants” saw inflation moving towards their 2% goal.
This is a very important topic to understand if you want to protect the wealth you’re building through dividend stocks.
So today, I want to talk a bit about why investors are worried about inflation and what this means for your retirement…
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Good Inflation Versus Bad Inflation
We’ve been taught that inflation is a bad thing for most of our lives. That’s because it seems “wrong” that things cost more and more over time. Especially if you’re living on a fixed amount of savings or income and inflation makes it harder for your resources to stretch.
But did you know that inflation isn’t always a bad thing? In fact, a moderate amount of inflation is actually considered a good thing for the economy.
Good inflation occurs when an economy is growing and there is more demand for important things like food, manufactured products, energy and even human capital. As demand picks up, people and businesses are willing to spend more for the things they need. And this steady rise in demand can trigger higher prices — or inflation.
One of the first signs of inflation we saw this year — the one that is partially to blame for sending the market lower — is an uptick in wages. For the month of January, U.S. wages rose an average of 2.9% over the same period last year.
Do you think the millions of workers who have received a 2.9% boost to their paychecks consider this “bad inflation”?
These wage increases are part of a healthy, growing economy that is willing to pay more for the work that individuals do. It also helps that tax cuts have left corporations with more cash to spend on higher hourly wages, higher salaries, bigger bonuses and other employee benefits.
Today’s level of inflation is right in the sweet spot for a growing economy. It’s not too hot and not too cold. If inflation were to move sharply higher, we’d have to worry about whether individuals could afford higher costs of living. And if inflation were to move sharply lower, it would be a worrisome sign that the economy isn’t growing as robustly as we thought.
But for now, I’m very comfortable with the level of inflation we’re seeing today.
Higher Inflation Leads to Higher Interest Rates
One of the reasons investors reacted poorly to the January wage increase is because inflation naturally leads to higher interest rates. And higher interest rates can sometimes cause problems for businesses and the economy.
There are two reasons why interest rates track closely with inflation.
The first one is “natural.” In other words, it occurs because of free market forces.
When inflation starts to kick in, consumers have an incentive to spend money quickly. After all, if you save your money, it will lose value if inflation is very high. So people typically pull money out of banks and spend cash or invest it in “stuff” that will hold value, like gold.
In order to keep people from pulling all their money out of bank accounts, banks have to offer higher rates. So the natural flow of money automatically leads to higher free-market interest rates.
The second reason is more “forced.” In other words, government (or Fed) intervention intentionally jacks up interest rates.
When the Fed becomes concerned that inflation is too high, the primary weapon against high inflation is an aggressive hike in interest rates.
The logic goes that if the Fed hikes rates, it will once again give consumers an incentive NOT to spend money right away but to keep that money and earn interest on it. Of course, for this to work, interest rates have to be higher than inflation rates. Otherwise consumers would still be losing value by not spending the money right away.
The higher inflation levels from January data have led some investors to start speculating about the Fed being more aggressive in hiking interest rates. But as you can see, the current levels of inflation are not anywhere close to being high enough to really worry about the dangerous effects of “bad” inflation.
How Do Inflation and Interest Rates Affect Our Positions?
The biggest issue that I’m watching right now is how interest rates compare with the income that investors are receiving from dividend stocks.
Right now it’s not a fair contest at all.
Let’s use my Lifetime Income Report portfolio as an example…
Most of our positions are earning dividend yields of anywhere from 3–5% or more. That’s well above the 2.16% yield that Treasury bills are paying right now.
Plus, it gets even better because we’re invested in companies that are not only paying us lucrative dividend yields, but also growing their business and in turn growing their payments.
So we can expect our dividends to increase over time, and we can also expect the share price for our stocks to appreciate over time.
That’s very different than when you invest in a CD at a bank or buy Treasury bills with your savings. With these investments, you’re guaranteed to only receive a specified return. No more, no less (unless of course the bank or the U.S. defaults on their promise).
If interest rates move sharply higher a few years down the road, that might be cause for alarm and reason to take some profits off the table from our dividend positions. But for now, with inflation levels tame and interest rates still very low compared with historical standards, our positions are in great shape.
The only thing I would recommend today is to think about overweighting our income positions that are tied to natural resources such as gold and oil or tied to construction and infrastructure spending. Because these positions should actually benefit from an uptick in inflation thanks to higher prices for the resources and projects they cover.
Here’s to growing and protecting your wealth!
This article originally appeared on The Daily Reckoning.