What to do with your 401(k) during high inflation

LAST REVIEWED Jun 28 2022 11 MIN READ

By The Human Interest Team + Independent Freelance Contributor*

Key Takeaways

  • High inflation and rising interest rates have caused some economists to predict an upcoming recession

  • But market volatility is a normal part of the economy—and it shouldn’t necessarily deter you from investing in a 401(k)

  • Luckily, there are steps you can follow to help you plan during times of economic uncertainty

Trying to decipher the state of the U.S. economy in 2022 can feel like an overwhelming, confusing task. Some economists predict an impending recession. Bloomberg recently estimated that there is close to a 75% chance of recession by early 2024. Others seem to find one much less likely, with some warning of misleading headlines. 

Small business owners may be the most worried about an impending recession. A CNBC survey found that 44% of small business owners rate the current economy as poor. Just 6% of small business owners find the current economy to be excellent. 

Supply chain disruptions are still making it difficult for companies to rebuild after the pandemic. And, the labor market is still rebounding after the great resignation. It’s not surprising that small business owners feel uneasy about all the uncertainty. So, what’s really happening with the economy and inflation? And, how does that affect retirement investments? Let’s talk about it. 

What is inflation?

Let’s start with the basics. The term “inflation” is often thrown around among economists and investors, but what is it? Inflation means that the purchasing power of money has decreased. For example, if a gallon of milk cost $0.75 in 1950, but it costs $3.75 today. 

Inflation can be measured by looking at the prices of certain goods. Economists use a measurement tool called the Consumer Price Index (CPI). The CPI looks at a collection of commonly purchased items and evaluates how much they cost throughout multiple years. To put it simply, the CPI might look at the cost of a loaf of bread, an apple, and peanut butter and evaluate how their cost changes over time to determine the rate of inflation. 

Does inflation cause a recession?

Inflation over time is normal, but inflation that happens quickly or suddenly can cause some uncertainty in the economy. Yet, this doesn’t mean inflation always causes a recession. A recession is a period lasting more than a few months where there is a significant decline in economic activity that can be seen in production rates, trade activity, and employment levels. 

Economists disagree on what exactly causes a recession, but it typically happens when multiple factors impact the economy. And while inflation can be involved in the events leading up to a recession, it isn’t the sole contributing factor. 

The state of the U.S. market today

It is true that inflation rates are currently high. The annual rate was 8.6% from May 2021 to May  2022. Low supply combined with high consumer demand means prices have been forced up. You may be noticing this in gas prices as well as in your grocery store aisles. In fact, food prices jumped nearly 11% year-over-year in April 2022, the largest 12-month surge since 1980.

In addition, interest rates are rising across all different types of loans. This is due in part to the Federal Reserve (the Fed) increasing interest rates. The interest rates controlled by the Fed impact how much banks and financial institutions pay to transfer money between themselves. Higher interest rates from the Fed mean lending money costs more money for the banks, so the interest rates of all loan types go up. 

On June 15, 2022, the Fed raised interest rates by 0.75%, the highest jump since 1994. These efforts by the central bank seek to address growing inflation. Because inflation is driven by consumer demand, interest rates can be used to help curb spending. Following the hike, Bloomberg Economics raised the probability of a recession to nearly 75% by early 2024.

Fed rate increases have also impacted the stock market. An increase in the federal funds rate essentially makes money more expensive to borrow for banks. As a result, the banks charge individual consumers more to borrow money. This means consumers have less disposable income, so they spend less. Less consumer spending means less money flowing into businesses. So the stocks you invest in may go down in value as interest rates go up. 

Understanding market volatility

Due to the COVID-19 pandemic and other resulting factors, the economy has seen rapid ups and downs over the last few years. As a result, the stock market has varied over that time period, too. In situations like the pandemic, it’s not uncommon to see high market volatility like this. 

Market volatility results from how quickly or slowly the market goes up and down. A market that changes rapidly and fluctuates over a short period of time is considered to have higher market volatility. If the market stays relatively stable with changes happening steadily over time, it has lower market volatility. 

Market volatility may change because of a few things:

  • Political events: The election of a new president or the outbreak of war can have impacts that make the market both go up and down.

  • Changes in the economy: Inflation, GDP rates, and consumer spending changes can all have an impact on market volatility, just to name a few. 

  • Shifts in a specific industry: If a specific industry sees drastic changes due to unforeseen events like weather or a political event, the market volatility can increase.

  • The performance of a large company: If a larger company sees changes that either increase or decrease investment in their stocks, this can sometimes affect the broader market.

Right now, we are seeing multiple of these factors happening at once. The war in Ukraine, high inflation rates, and supply chain shortages are just a few of the factors contributing to high market volatility in mid-2022.

Investing is a long game

High market volatility shouldn’t necessarily deter you from investing or starting a 401(k). Investing in the stock market always involves some risk. Market volatility is a normal part of investing, and it can even help you get a good deal when you start investing. 

The market consistently changes. When you are investing for your future, you may see many changes in the market over time. In fact, while past performance does not guarantee future results, the S&P 500 index—often considered a benchmark of U.S. stock market performance—has seen an annualized average return of nearly 10.5% from 1957 through 2021. Of course, that number is not without its peaks and valleys. But this doesn’t mean you shouldn’t invest. 

Planning for a recession

It’s a good idea to think about how the current market may impact your 401(k). Yet, this shouldn’t cause you to pull investments or stop you from investing altogether. 

Consider decisions and adjustments you can make in your portfolio that will help set up your investments to help weather economic change well:

  • Diversify* your investments: Investing comes with inherent risks. While stocks historically offer a higher rate of return, they have carried higher risk. Bonds may be considered a safer investment option, but historically offer lower returns. Investing in mutual funds—which may include stocks, bonds, and other securities—can help make diversification more accessible, including helping you to invest in a mix of investment types to help mitigate risk. 

  • Rebalance your portfolio: Evaluating your 401(k) portfolio and how different assets have performed over time gives you the opportunity to reallocate your investments Different investment types react differently to the same market conditions, which can cause your portfolio to fluctuate as the market moves. Rebalancing your holdings can help bring your portfolio back into its desired asset mix.

  • Keep some cash on hand: It might be a good idea to keep enough cash on hand to sustain you for a few years, especially during times of economic uncertainty. Having a chunk of money you can access allows you to cover living expenses while you wait out any economic downturns that may occur during the early years of your retirement. 

*Diversification does not assure a profit or protect against loss. 

The bottom line

Inflation and market changes are a normal part of the economy. The threat of a recession shouldn’t keep you from investing. If you do your research and set up your 401(k) well, you can help plan for uncertain times like these in the market. 

If you are a small business owner looking for 401(k) options, think about working with Human Interest. Learn more about what we have to offer.

*Emma Woodward is an independent contractor commissioned by Human Interest to help contribute to this article.

We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.