WHAT YOU NEED TO KNOW
Inflation is a popular topic in the financial media this spring. This short article is written to provide clarity on this topic and clear up misconceptions that investors might have.
Inflation Definition and History
Inflation is a term that describes the general increase in the cost of products and services, as well as a decline in the purchasing value of money. Some notable examples of inflation are the cost of college tuition, medical care and residential real estate, which increased in the last 25 years. A simple explanation of what causes inflation is that too many dollars are chasing too few goods.
A recent example of excessive inflation in the United States was in the 1970s, when inflation averaged more than 7% annually. Almost unfathomable today, interest rates reached 16% to 17% for a brief time when wages were sticky, retirees had healthy pensions, unions were powerful, and it was difficult for companies to lay off employees. The country also experienced two different oil shocks during the decade, which played a key role in rapidly rising prices.
Inflation is often measured by the consumer price index (CPI), which has been at or below 2.5% for most of this decade and has averaged 1.7% over the last 10 years.
You may be aware of why this topic is gaining traction today. In response to the COVID-19 pandemic, the federal government has gone to great lengths to ignite the economy. Forgivable business loans and multiple rounds of stimulus checks to individuals put cash into the financial system. The Federal Reserve has increased the money supply by purchasing treasury bonds and mortgage-backed securities while lowering short-term interest rates to effectively 0%.
The Fed has also stated that they want inflation, specifically suggesting they want to shoot for a sustained period with inflation exceeding 2%. So why haven’t we experienced any significant inflation? The amount of money in the U.S. economy is estimated to be 25% higher than it was at the beginning of 2020. Yet, we have not experienced a corresponding change in the velocity of that money, which is a measure of how quickly cash circulates in the economy. Simply put, businesses and individuals are unwilling to spend money.
Consider the example in which 10 people each receive $1 million and bury it in their backyards. The extra $10 million has no economic effect and therefore has no impact on inflation. On the other hand, consider the implications if those individuals spend the $10 million at two to three businesses each. The businesses may need to hire more employees and replace inventory, which could involve multiple suppliers. Each supplier may need to manufacture more goods to establish their inventory. Imagine this cycle repeated thousands of times and you can begin to understand why the velocity of money is an important component of inflation.
Savings and Pent-Up Demand
Today, U.S. saving rates have soared, nearly doubling in 2020, because consumers have been unable to travel, dine out or shop in stores to the extent they did before the pandemic. Based on these data, one would expect there is tremendous pent-up consumer demand.
At the time of this writing, COVID-19 vaccines are widely available to adults who want them and the expectation on Wall Street is the velocity of money will pick up soon. We will have more money in the financial system, an increase in spending and, therefore, an increase in the velocity of money.
However, this probably does not mean hyperinflation is inevitable. Some level of inflation is likely, which would be good news for the economy. However, hyperinflation can cause economic disruption. Deflation, which is the rapid fall in prices, is just as bad as, if not worse than, inflation because it creates an environment where consumers are waiting to spend money. This is problematic for an economy like in the United States, 70% of which is driven by consumer spending.
Impact on Investments
The consensus on Wall Street is that we will experience some form of modest inflation this year. In fact, we are seeing growing concern that inflation will quickly shoot past the Fed’s target rate of 2% annually. However, the Fed has multiple tools at its disposal which are believed will successfully control the increase in costs. Much of the concern is around the ability of the economy to meet what is perceived as great pent-up demand.
In theory, companies can quickly hire and ramp up production to keep up with increasing demand. The counter-argument is that rapidly increasing demand will exceed supply. Companies will not be able to adequately ramp up production and the country will have too many dollars chasing too few goods. In this scenario, we would see sharp price increases due to scarcity and we may also see disruptions in the supply chain.
The bottom line, and what this means for your investments, is modest inflation has traditionally been positive for stocks. Equities are generally a nice hedge against the erosion of purchasing power, as opposed to bonds. Typically, rising interest rates follow inflation and rising rates can negatively impact the pricing of most traditional bonds. Yet, bonds remain a critical tool in managing investment risk for many investors and their portfolios.
If inflation is a concern and bond-type protections are still important, one option to understand is treasury inflation protected securities (TIPS), which are designed to protect investors from the risk of higher than anticipated inflation. TIPS will adjust their principal based upon changes in the CPI and pay out a fixed coupon rate on the principal. As the size of the principal is adjusted, the coupon will also change and therefore will increase or decrease with changes in CPI. Because the structure of TIPS can be somewhat complicated, contact a professional investment advisor to learn more about the pros and cons of these investment vehicles.
Investing can be complicated. The potential scenarios associated with inflation are too extensive to cover in a short article. The good news is that inflation is not typically destructive to an investment strategy. In fact, inflation is often welcome. If you have a diversified mix of investments, you probably don’t need to make drastic alterations to your approach. We encourage you to contact your financial advisor prior to making any changes to your portfolio.