Economics 101: A Fiscal Policy Dilemma

How Long Will Economic Recovery Take?

As troubling as these times look, we all assume that eventually things will change and the economy will once again be robust, financial markets will stabilize, and commodity prices will revert to the mean.

In the mean time, however, many financial pundits are taking their best guess as to how long the recovery process will take. We are constantly barraged in the media with a mixed bag of opinions, all of which are given without request mind you, and all trying to influence government policy makers to either reign in pricing or make borrowing money easier.

Will We See Stagflation?

The puzzling duo of slow growth and high inflation is extremely troubling for policy makers because combating one ailment only serves to exacerbate the other. A true economic Catch-22 if you will. It is widely thought that the central banks will leave the overnight rate unchanged until year end as a tightened credit policy may send the economy into a severe downward spiral.

The current state of affairs has even the most seasoned economists scratching their heads:

“That’s the dilemma that rapidly rising high oil prices create for central banks everywhere. It boxes them in,” said Douglas Porter, deputy chief economist with BMO Capital Markets.

“It has the nasty side-effects of crimping growth and driving up inflation. This is like a mini-version of what central banks faced in the 1970s when oil prices spiked.”

The era that Porter speaks of was marked by what has since been termed stagflation – a persistent period of economic stagnation and high inflation.

The Numbers Tell The Story

In uncertain times like these, it is even more prudent to look at the hard data to provide the “real” truth behind the economy. The following are sets of numbers that help us to understand the effect that skyrocketing energy prices are having on consumers:

  • Consumer Prices were ups 1.1% last month – The largest monthly increase in over 25 years!
  • Energy prices are up 6.6% since last month.
  • Inflation adjusted average weekly wages dropped 0.9% last month. This was the largest drop in wages since 1984.
  • Consumer inflation is up 5% over the last year – The highest since 1991.
  • Airline prices were up 4.5% in June – The biggest one-month jump since early 2000.
  • Vegetable prices were up 6.1% in June – The largest monthly increase in three years.

What Can Investors Do?

In any inflationary environment the common practice says to keep existing outflows down, skip new large expenses, and increase your emergency savings. I would like to personally add that we should continue to invest in equity markets as long as we have time on our side (7-10 years).

Increase emergency funds and review life and health insurance.

The 3-6 months’ worth of expenses that advisors suggest we keep stashed away in liquid assets such as fixed deposits or a high interest savings account could be increased.

Life and health insurance should be reviewed and could be topped up with low-cost term insurance if necessary. Shop around for no-obligation insurance quotes. InsureMe.com offers quotes on all types of insurance and are very competitive.

Prepay your mortgage.

As mortgage and interest rates may climb higher, prepaying your loans will give you a guaranteed return on your investment equal to the interest rate on the loan. Moreover, no single investment option is likely provide guaranteed returns greater than the rate of interest on your mortgage. In addition, the psychological satisfaction of reducing your overall debt can trump any financial return. This is especially true for the conservative investor.

If you are concerned about rates increasing, you might want to lock in the interest rate on your mortgage with a fixed rate loan. If you have a good credit score, banks will likely really want your business as lending regulations are tightening. This would be a good opportunity to have a service like LendingTree.com working for you to get the best rate.

Continue to invest in stocks.

The only opportunity that we have to combat inflation is to investing in equity. Carry on with your stock investment strategy and take advantage of buying opportunities in great dividend growth stocks. For the moderately conservative investor, seek out large cap stocks that are trading at least 30% off of their 52-week high and have stable earnings as they are likely to rebound first.

If you want to pick up stocks, invest in stages and go for value dividend growth buys. If your time horizon allows, a great buying opportunity may be upon us. Remember, history is on your side.

Diversify in precious metals.

While Gold and Silver are at high prices, some advisors still recommend that you invest 5-10 per cent of your portfolio in gold exchange-traded funds and gold mutual funds. Their reasoning for this suggestion is that, historically speaking, periods of high inflation result in a surge in gold prices.

What are your plans for this economy?  Are you buying, selling, or staying the course?

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