Island Investing: Inflation

From my column in today’s Keys Weekly. Also, Key West editor Josie Koler is now on Twitter, too. She’s @josiekwweekly.

Q. How concerned should I be about inflation?

A. Be concerned, but don’t panic yet.

Inflation is an increase in the general level of prices of goods and services. When the level of prices rises, a dollar buys less today than it did yesterday. So inflation erodes the purchasing power of money, penalizing people who save.

The rate of inflation depends on growth in the money supply. Because the government has flooded the economy with money to rescue the banking system, it’s very likely we will eventually see higher inflation.

Traditionally, central banks like the Federal Reserve raise interest rates to slow the growth in the money supply and keep inflation in check. Given the amount of money injected into the economy lately, however, there is concern about how fast inflation will rise once it does appear – and how high interest rates will have to be raised in order to control it. Higher interest rates make borrowing money that much more expensive, crimping economic growth.

What’s that mean for investors?

There is no shortage of opinions about the best way to “inflation-proof” your portfolio, but don’t let the tail wag the dog. Those with the most to lose in a surge of inflation will be holders of bonds and other fixed-income assets. Stock investors should consider whether the companies they own are in a strong enough competitive position to pass on any increases in costs to consumers. Commodities like oil, grains and metals also increase in price as inflation rises.

Inflation is the friend of the real estate investor, too, assuming a fixed-rate mortgage. Historically, real estate appreciation has outpaced inflation by a few percentage points a year. By borrowing money through a fixed-rate mortgage, you are using leverage to magnify that gain even more over time.

In addition, while income increases as inflation does, a mortgage does not, so real estate owners will be paying off debt with money that is really worth less than the cash that was originally borrowed. More notably, you’ll also have more cash left over at the end of every month.

Cale Smith

About Cale Smith

Portfolio Manager at Islamorada Investment Management.

This entry was posted in Island Investing and tagged . Bookmark the permalink.