What Is Inflation?
Inflation is a measure of how much prices for goods and services are rising in an economy.
Inflation can be caused by a number of factors.
Demand-pull inflation occurs when there is more demand for goods or services than the supply can meet. This allows companies to raise prices in the face of excess demand.
Cost-push inflation occurs when cost increases make it more expensive for companies to produce the same goods or services. Companies raise prices to maintain their profits.
Government or central bank policies can also impact inflation. If the money supply is increased or the government injects extra liquidity into the economy through stimulus programs, there is more money chasing the same amount of goods, which could cause prices to rise.
Even expectations about inflation can affect the rate of inflation. If workers expect more inflation, they may demand higher wages. Those wage increases may increase the cost of producing goods, which may result in higher prices. The expectations become self-fulfilling.
Is inflation good or bad?
If inflation remains at reasonable levels, it can be healthy for an economy. The Federal Reserve has set an official inflation target of 2%. At this level consumers expect prices to rise, so they buy now rather than paying more later. This increases short-term demand, causing sales and employment growth and increased factory production. The economy benefits.
But even modest inflation erodes purchasing power over the long-term. According to the Bureau of Labor Statistics, $1 in 1990 was equivalent in purchasing power to about $1.98 at the end of 2020. The average inflation rate was only 2.3% during that period, yet that $1 lost almost half of its purchasing power in 30 years.
If the inflation rate accelerates beyond modest levels, it can have a dramatic negative impact on each dollar’s purchasing power. The prices of goods and services rise faster than wages can keep up. These increases can be particularly hard on those with fixed incomes.
Recent changes in inflation
The inflation environment is always changing. For the 10 years ended December 31, 2020, inflation remained low, increasing by an average annual rate of 1.75%. However, for the 12 months ended December 31, 2021, inflation rose by 7%. This is far less than in 1974, 1979, and 1980 when inflation exceeded 12%, but it still represents a significant increase.
This spike in inflation has been attributed primarily to causes related to the COVID-19 pandemic. As restrictions loosened and the economy opened, consumers eagerly resumed shopping, traveling, and dining at their favorite restaurants. Government stimulus payments designed to boost the economy further fueled this pent-up demand.
Disruptions to the global supply chain and the labor force caused by the pandemic have made keeping up with the demand for goods and services difficult. When demand outstrips supply for a prolonged period, elevated inflation is a likely result.
What to expect going forward
Experts disagree about whether the current rise in inflation is temporary or will be with us for an extended period. But markets are relatively efficient and can tell us much about what to expect in terms of future inflation. By comparing the difference in yields between a Treasury Inflation Protected Security (TIPS) and a traditional Treasury security, we get a good sense of the market’s expectations about the future inflation rate.
As of December 31, 2021, the 10-year Treasury bond yield was 1.52%. The 10-year TIPS yield was -1.04%. The difference, 2.56%, is the market’s estimate of inflation over the next 10-years.
Although the market’s estimate of future inflation is not a precise indicator, it has done a reasonably good job of forecasting it.
What to do about inflation
Financial markets incorporate expectations about future inflation into the prices of all assets. Therefore, to reposition a portfolio in the face of rising inflation expectations and benefit from those changes, you must have a belief that inflation will rise (or fall) more than the market expects it to. Then you must reposition your portfolio accordingly and be right in your belief.
If an investor believes that inflation will exceed the market’s expectations or is particularly concerned about the risks and impact of inflation, there are several commonly cited strategies that can be used. As with virtually all investment decisions, there are risk and return implications associated with each alternative.
TIPS are one of the most often cited hedges against inflation. Like other Treasury bonds, TIPS are issued with a fixed coupon rate. But their principal value is indexed to inflation, as measured by the Consumer Price Index for all Urban Consumers (CPI-U). That means their principal value rises and falls with changes in the rate of inflation.
To benefit from investing in TIPS rather than traditional Treasury bonds, real future inflation must be higher than current market expectations. If it is not, an investment in TIPS will provide no benefit and may even cost the investor.
One downside of investing in TIPS (and Treasuries broadly), at present, is that investors are “locking-in” a negative real rate of return at current prices. With 10-year TIPS recently yielding -1.04%, an investor that buys and holds until maturity will earn the realized CPI minus over 1%.
Further, the CPI may not be an appropriate measure of inflation for all investors. It is a broad statistical measure of the price of goods and services across the country.
Local factors and specific influences may have a more meaningful impact. For example, rents and housing prices in many areas of the country bear very little resemblance to CPI. The principal value of TIPS will track changes in the CPI but may not reflect those local factors.
Gold is often positioned and marketed as an inflationary hedge. The reality is that its actual inflation protection characteristics are not particularly compelling.
Research done by Morningstar showed that gold did serve as a hedge against inflation when inflation reached historically high levels in the 1970s. However, during the milder inflationary periods from 1980-1984 and 1988-1991, it had negative returns and underperformed large-cap stocks by a wide margin.
Our research shows that over the long-term, gold’s performance tends to lag that of both stocks and bonds. Between January 1987 and December 2020, gold returned 4.57%, while U.S. bonds returned 5.91% and U.S. stocks returned 10.64%.
During this period, the volatility of these asset classes, as measured by standard deviation, was 15.12% for gold, 3.80% for U.S. bonds, and 15.42% for U.S. stocks. Gold returned less than U.S. bonds, but was about as volatile as U.S. stocks, which had far higher returns.
Research shows that gold has excelled in down markets and periods of high volatility. However, use of gold as a reliable inflation hedge is questionable and overweighting it in a portfolio at the expense of stocks, for example, can detract from long-term performance.
In the short term, stocks can take a hit from rising inflation, particularly if it causes the Federal Reserve to raise interest rates. However, over time the stock market adjusts as companies pass on higher prices to consumers.
This makes the stock market perhaps the best vehicle for outpacing inflation and growing wealth. Since 1926 the long-term inflation rate has been 2.88%, while the inflation-adjusted average annual return through the end of 2021 for the S&P 500 index has been 6.82%.
Even during periods of higher inflation, the stock market often performs well. In the last 80 years, there have been five periods of higher inflation: 1941-1951, 1966-1980, 1987-1992, 2002-2008, and 2020-2021. In four out of those five inflationary periods, the S&P 500 has essentially equaled or outperformed its long-term average return of 6.82%.
Rising inflation is often accompanied by rising bond yields as the market incorporates higher inflation expectations into its pricing. Rising yields means current bond holders will suffer a decline in the principal value of their bonds. But those losses are often temporary.
As their bonds mature and as they receive interest payments from the bonds they still hold, investors can reinvest those amounts at the new higher interest rates. Depending upon the circumstances, they could make back any losses they experienced in a relatively short period.
Even if bond holders suffer temporary losses in the short term, their bonds still play an important role in their portfolios. Those bonds can help preserve capital due to their lower volatility and can reduce overall portfolio volatility due to their low correlations to stocks.
For example, research by Vanguard showed:
- When stocks worldwide sank an average of 34% during the global financial crisis, the market for investment-grade bonds returned over 8%.
- From January through March 2020 – the height of volatility in stocks due to the COVID pandemic – stocks fell by almost 16%, while bonds worldwide returned just over 1%.
- From January 1988 through November 2020, when monthly stock returns were negative, monthly bond returns were positive roughly 71% of the time.
This research shows the important role bonds can play in capital preservation and volatility reduction, regardless of the direction of interest rates.
Moving to cash during a period of rising inflation is almost guaranteed to cost an investor dearly. Cash is unlikely to keep up with rising inflation and is likely to be pulled from an allocation in the portfolio that would better maintain its value. Stay fully invested.
Inflation rates vary around the world. Spreading portfolio assets across different countries and regions can buffer the portfolio from an unexpected spike in inflation in any single country.
How investors should deal with inflation
Nothing will immunize a portfolio from the impact of rising inflation. Financial markets are relatively efficient and react quickly to new information, including information about rising inflation. Inflation expectations are reflected in all asset prices.
To benefit from changes in inflation, an investor must have a view that is different and more accurate than the view incorporated into current market prices. Then the investor must make portfolio adjustments that are later rewarded by the market. This is hard to do consistently.
There will always be analysts and pundits who offer prescriptions designed to address or minimize the impact of inflation. Some have a vested interest in their prescriptions, while others are genuine in their beliefs. None have fool-proof solutions.
An investor’s best bet for dealing with inflation is to:
- Invest in a well-diversified portfolio constructed to reflect the long-term return objectives and risk profile of the investor.
- Maintain exposure to stocks consistent with the investor’s objectives and risk profile.
- Keep portfolio costs and expenses low.
- Trust in the relative efficiency of the financial markets.
- Screen out the noise and have patience.