Understanding Inflation
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 current 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.
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 October 31, 2021, inflation rose by 6.2%. 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 up again, 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. At the end of June 2021, the 10-year Treasury bond yield was 1.47%, while the 10-year TIPS yield is -0.87%. The difference, 2.34%, is the market’s estimate of inflation over the next 10-year period.
Although the market’s estimate of future inflation is not a precise indicator, historically it has done a reasonably good job of tracking 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 unique risk and return implications associated with each alternative.
TIPS
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). That means their principal value rises and falls with changes in the rate of inflation.
Keep in mind that 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.
For a more detailed review of TIPS please see, “Understanding Treasury Inflation-Protected Securities (TIPS).”
Gold
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 shows 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 showed negative returns and underperformed large cap stocks by a wide margin.
Our research shows that over the long-term, golds performance tends to lag that of both stocks and bonds. Between January 1987 and December 2020, gold returned 4.57%, while US bonds returned 5.91% and US 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 US bonds, and 15.42% for US stocks. Gold returned less than US bonds, but was about as volatile as US stocks, which had far higher returns.
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.
For a more detailed review of gold, please see, “The Glitter of Gold.”
Stocks
In the short-term, stocks can certainly 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 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%.
Bonds
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 their bonds, investors can reinvest those amounts at the new higher market rates. Depending upon the circumstances, they can often 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.
Cash
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.
Global Diversification
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.
The Bottom Line
There is no silver bullet that will immunize a portfolio from the impact of rising inflation.
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.