The Effect Of Higher Inflation On Your Investments

FINANCIAL FOCUS

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Gas prices, affordable housing, health care costs -- inflation has been in the local, state and national news quite a bit lately. After years of enjoying mild inflation rates, we may be entering a period in which we experience more significant price increases on a broad range of products and services.

As a consumer, you can see what increased inflation might mean to you. But will higher inflation hurt your investments?

Before you can answer this question, you need to be familiar with a little monetary policy, as set by the Federal Reserve, our nation's central bank. If the Fed believes that we face substantial increases in the cost of living, it will try to "cool off" the economy by raising short-term interest rates. And that's just what it has done over the past couple of years.

So, there's typically a positive correlation between rising inflation and higher short-term interest rates.

Now we can return to our initial inquiry: Will inflation harm your investments?

The answer: It depends.

In the short run, when interest rates rise, it becomes more expensive for companies to borrow to finance their operations; consequently, their profit margins may be squeezed and their stock prices might fall.

Yet, in the long run, inflation allows companies to raise prices, thereby boosting the dollar value of their sales and earnings. And the threat of higher prices may spur people to buy sooner, rather than later, so some consumer-oriented businesses may actually benefit from inflation. If that happens, their profit outlook may improve, as will their attractiveness to investors.

In short, if you own stocks, the threat of inflation, by itself, is no reason to panic. However, you may want to look over your portfolio with your financial professional to see if you should make adjustments, because different market sectors will respond differently to higher interest rates.

Inflation: Bad News for bonds?

When the Federal Reserve responds to the threat of inflation by raising short-term interest rates, bond prices can fall. That's because people will not pay face value for your bonds if newer ones are available with higher interest rates.

However, most investors buy bonds for the income they provide. So, if you hold your bonds until maturity, or they are "called" (redeemed early by the issuer), you will still receive

interest payments along the way and get your initial investment back when the bonds mature.

If you would still like to help improve the long-term outlook for your fixed-income investments, you might want to build a "bond ladder" by purchasing bonds of varying maturities -- short-, intermediate- and long-term.

A bond ladder prepares you for both rising and falling interest rates. When rates are rising, the proceeds from your maturing bonds can be used to invest in new bonds at the higher levels. When market rates are falling, you may not be able to purchase new bonds at the previous rates, but you'll continue to benefit from the higher rates offered by your longer-term bonds.

Review Your Options

Worries over inflation are real, but, in the long run, they may be overblown. As we've seen, the Federal Reserve is actively fighting inflation, and it has been pretty successful at doing so for the past couple of decades. But in any case, it's not a bad idea to be prepared for inflationary pressures by reviewing all your options with your financial professional.


Ross Hage is a licensed investment representative with the firm of Edward Jones. For more information, call him at (928) 468-2281.

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