BY WEALTH ADVISER
Introduction
Inflation is a pervasive economic force that can significantly impact the financial well-being of retirees. As prices rise over time, the purchasing power of savings and fixed incomes can erode, making it more difficult to maintain a comfortable standard of living. To effectively plan for retirement in an inflationary environment, it is crucial to understand the relationship between money supply and inflation. This article will explore the money supply and inflation connection, analyze current trends, and discuss strategies for generating inflation-adjusted retirement income.
The Money Supply and Inflation
Connection At the heart of the relationship between money supply and inflation lies the MV = PT identity. As explained by Warren Bird in his article “This vital yet ‘forgotten’ indicator of inflation holds good news,” this economic identity states that the nominal value of goods and services produced in an economy (P, for prices, times T for real value of transactions) is equal to the amount of money (M) in circulation and how rapidly it circulates (V, for velocity). When there is excessive money supply growth beyond the capacity of the real economy to keep up, the result is rapidly rising prices for goods and services, or inflation.
Historical examples demonstrate the link between money supply growth and inflation rates. Bird notes that “the sharp increase in Australia’s inflation rate in 2022 was both caused by and was predictable because of the surge in money supply growth during 2020.” He argues that the Reserve Bank of Australia (RBA) was too slow to respond to the monetary evidence and that tighter policy should have been implemented earlier to bring money supply growth back to acceptable levels..
The Current State of Money Supply and Inflation
Recent trends in money supply growth and inflation rates have been a cause for concern among economists and retirees alike. As Michael O’Neill points out in his article “Inflation uncertainty makes retirement planning harder,” when inflation resurfaces, predictions about its trajectory and the path of interest rates can change rapidly. Global inflationary forces, such as supply chain disruptions, geopolitical tensions, and the push to reduce emissions, have contributed to the current inflationary environment.
The Economist has described Australia as having the developed world’s most entrenched inflation, with services inflation remaining particularly sticky and problematic. While there is hope that advancements in artificial intelligence (AI) could lead to increased productivity and deflationary pressure, the short-term impact of AI investments may actually contribute to inflation.
Implications for Retirees
Inflation poses significant challenges for retirement planning and income generation. As O’Neill explains, “The closer you get to retirement the more any investing missteps matter. It has always been hard for retirees to work out how much money they need to retire as there are so many variables -- investment performance, health, longevity, unexpected expenses -- the list goes on. Now, with the cost-of-living increasing more quickly, and high uncertainty when inflation will return to normal levels, the sum of money people need to save to live comfortably for the rest of their life, is even harder to estimate.”
Retirees are faced with a dilemma: either take on greater investment risk to improve returns and stay ahead of inflation, or invest more conservatively but earn lower real returns and hope that inflation will come down quickly. Relying solely on market-linked investments for inflation protection can be risky, as historical data shows that it can take more than a decade for markets to recoup lost income during periods of high inflation.
Strategies for Generating Inflation-Adjusted Retirement Income
To navigate the challenges of retirement in an inflationary environment, retirees can employ several strategies to generate inflation-adjusted income. Social security benefits, which are indexed to inflation, provide a valuable foundation for retirement income. As Bob French notes in his article “How to generate inflation-adjusted income in retirement,” “There are a lot of reasons to like social security, but from a financial planning perspective, one of the big ones is that your social security benefits are adjusted for inflation. However big of a piece of your social security benefits make up of your retirement income, you’ll always be able to (roughly) buy the same amount of stuff with those benefits.
Beyond social security, retirees can explore annuities and other financial products that offer varying levels of reliability and inflation protection. Income annuities, for example, can be used in a “sequential” manner to top up reliable income over the course of retirement as the impact of inflation is felt. By using multiple annuities over time or partially annuitizing one annuity, retirees can maintain greater control over how their income level evolves to keep pace with inflation.
For those comfortable with a probability-based approach to retirement income, diversifying investments across stocks and bonds can help balance growth and stability. Historical data suggests that a well-diversified portfolio, such as a 60/40 mix of stocks and bonds, has a high probability of outpacing inflation over the long term. However, it is essential to recognize that there is always some risk involved, and no solution is perfect.
Conclusion
Understanding the relationship between money supply and inflation is crucial for retirees seeking to secure their financial future in an inflationary environment. By analyzing historical trends, current economic conditions, and the implications for retirement planning, retirees can develop strategies to generate inflation-adjusted income and maintain their desired standard of living.
A combination of social security benefits, annuities, and diversified investments can help mitigate the risks of inflation and provide a more stable foundation for retirement income. While no solution is perfect, and trade-offs must be considered, a well-informed and proactive approach to retirement planning can help retirees navigate the money supply and inflation puzzle with greater confidence and success.
References:
• Inflation uncertainty makes retirement planning harder (firstlinks.com.au)
• Protecting retirement income from inflation shocks (firstlinks.com.au)
• How to generate inflation-adjusted income in retirement (firstlinks.com.au)
• This vital yet “forgotten” indicator of inflation holds good news (firstlinks. com.au)
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