By: Reed C. Fraasa, CFP®, RLP®, AIF®
The story is well-known: if you place a frog into boiling water, it will jump out immediately. But if the frog is put in tepid water that is slowly heated, it will not perceive the impending danger and will eventually be cooked to death. This analogy is a powerful metaphor, cautioning us about the risks posed by gradual changes that go unnoticed—similar to the frog failing to react to the slowly heating water.
This metaphor aptly describes how people often fail to recognize or respond to gradual changes in their environment or circumstances. In financial planning, this concept underscores the importance of regularly monitoring a client's financial status to avoid being metaphorically "cooked."
The analogy also reflects how people have perceived and reacted to inflation in the post-COVID-19 era compared to the period between the Great Recession and COVID-19.
From January 1, 2010, to December 31, 2020, the average annual CPI inflation rate in the United States was approximately 1.8%. Inflation rates during this period were relatively stable, ranging from about 0.1% to 2.4% per year, with the highest annual inflation rate reaching 2.4% in 2018 and the lowest at 0.1% in 2015.
Over these 11 years, the cumulative inflation amounted to approximately 20.5%. This indicates that the purchasing power of $100 in January 2010 would require about $120.50 to buy the same basket of goods by the end of 2020. Despite this significant increase, during that period, there was little to no public discussion or media coverage of the impact of inflation.
However, the narrative changed drastically from January 1, 2021, to March 31, 2024. During this time, the average annual CPI inflation rate in the United States spiked to approximately 5.3%, with rates varying widely from about 1.4% to a peak of 9.06% in June 2022.
The cumulative inflation over this shorter period was about 15.9%. The sudden and sharp rise in inflation rates drew significant attention from the public and media alike, highlighting the stark contrast in perception when changes are abrupt versus gradual.
Interestingly, even though the cumulative inflation over the previous 11 years was over 30% higher than in the recent 3.25 years (20.5% vs. 15.9%), public reactions have been disproportionately alarmed by the recent inflation rates. There is a prevalent misconception that interventions from the President or the Federal Reserve could somehow reverse these recent cumulative inflationary increases. However, that is not how inflation dynamics work in the economy.
Over the past three decades, one of the most challenging concepts to convey to our clients has been the impact of inflation on purchasing power. While temporary losses in the stock market typically recover over time, the permanent reduction in purchasing power caused by inflation is much more challenging, if not impossible, to recoup.
Many people still do not fully understand the difference between inflation, deflation, and disinflation. Inflation is a sustained increase in the general price level of goods and services over time, reducing the purchasing power of money. Conversely, deflation involves a decrease in the general price level and can lead to a harmful economic cycle of reduced consumer demand and lower wages. Disinflation, however, is a slowdown in the rate of inflation, where prices continue to rise but at a slower pace.
After any period of inflation, there is no return to the prior price levels unless there is deflation. The Federal Reserve has accomplished disinflation, slowing the monthly inflation rate over the past 21 months. However, the expectation is that it will take additional time to bring inflation down to the Fed's final target.
The current persistent headline inflation, which includes significant contributions from volatile food and energy prices, is influenced by numerous factors. There is a myriad of forces at play that affect inflation.
The Consumer Price Index (CPI) inflation data comprises more than 200 categories arranged into eight major groups. These major spending categories include food and beverages, housing, apparel, transportation, medical care, recreation, education and communication, and other goods and services. Some of these categories are more volatile, meaning traditional supply and demand factors influence them more. This includes items like food and energy. That is why the Bureau of Labor Statistics issues two primary CPI numbers: Headline CPI Inflation and Core CPI Inflation.
Headline inflation measures the total inflation within an economy, including commodities such as food and energy prices, which tend to be much more volatile and prone to inflationary spikes. Specifically, headline inflation includes:
Food prices
Energy prices (e.g., oil and gas)
All other goods and services typically consumed by households
Headline inflation is contrasted with core inflation, which excludes the volatile food and energy sectors to provide a clearer picture of the underlying inflation trends.
The major contributors to the current state of inflation in 2024 include:
Global Crises and Supply Chain Disruptions: The ongoing international crises, such as the war in Ukraine, have significantly impacted global commodity prices, contributing to high food prices. Shipping disruptions in the Red Sea following the escalation in Middle East tensions with the Israeli/Hamas conflict have disrupted supply chains and increased costs for raw materials.
Energy Market Volatility: Energy prices have been influenced by geopolitical tensions, such as the conflict in Ukraine, which has disrupted energy supplies and increased reliance on alternative sources.
Corporate Practices and Inflation Dynamics: Some reports suggest that corporate consolidation and profiteering contribute to high prices. Companies have been able to raise prices more than their costs increase, leveraging strong demand and supply chain constraints to expand profit margins.
Labor Costs and Wage Increases: Increases in minimum wages and general labor costs in sectors like food service have also contributed to rising prices in restaurants and for food manufacturers, as these costs are often passed on to consumers.
Environmental Factors: Weather impacts, such as droughts and below-average rainfall, have affected hydropower generation and agricultural outputs, further straining food and energy supplies and keeping prices elevated.
Consumer and Fiscal Spending: Since the US economy is primarily driven by consumption, consumer and fiscal (government) spending has continued to stimulate the economy and keep prices higher. It is interesting to note that both Europe and Japan are experiencing lower inflation than in the US, and some of that can be attributed to less government stimulus and higher food and energy costs, causing consumers to spend less.
Housing Shortage: The shortage of single-family home inventories and multi-family vacancies has been a factor in higher housing costs. These numbers are expected to improve over the next several quarters. Multi-family vacancies are expected to increase due to significant new construction over the past year, and the recent trend in new single-family home starts should improve inventories. A change in the Federal Reserve's monetary policy later this year may also provide some relief in mortgage rates.
In summary, understanding and preparing for inflation is crucial in financial planning. The recent sharp increase in inflation rates, like the proverbial frog thrown into boiling water, should serve as a wake-up call highlighting the importance of maintaining a diverse portfolio, including equities, for long-term capital growth and preservation.
Disclaimer: No frogs were harmed while producing this article. 😊
Reed C. Fraasa is a CERTIFIED FINANCIAL PLANNER™ and founder of HIGHLAND Financial Advisors, a Fee-Only financial planning firm that offers comprehensive financial planning, retirement planning, and investment management. Reed has 30 years of experience as a fiduciary advisor and is the author of The Person is the Plan®, a unique financial planning process. Reed was a frequent guest contributor on PBS Nightly Business Report and has been featured in the New York Times, Wall Street Journal, and Star Ledger newspapers.