Inflation is the effect of the goods and services you like to consume getting more expensive over time. Another way to look at inflation is the money you use to buy things becoming less valuable, so you need more of it to purchase the goods and services you consume. Retirement savers are exposed to decades of potential inflation that may undermine the future purchasing power of their saving, so it is important to plan accordingly. In every financial plan we have made an assumption for the future rate of inflation and we study historical data to help us make this assumption. However, inflation has been coming down for the last 40 years so using historical data to predict the future must be carefully analyzed. Furthermore, the current rate of federal spending and stimulus could have an effect on inflation down the road. This is precisely why we use our Monte Carlo Simulation tool to stress test your financial plan and to model potential low and high levels of inflation over your lifetime.
Inflation is defined as a broad rise in prices. One-off increases in things like gas, college and medical expenses are not enough to generate sustained inflation. Inflation results when the demand for goods and services is greater than the supply. In other words, “too much money chasing too few goods.” When the demand for goods and services is greater than the economy’s capacity to provide them, prices will rise.
Increases in prices take wealth away from savers and devalue people’s wages and assets. There are many ways to measure inflation. The most widely used measure is the Consumer Price Index (CPI). It captures price changes for a broad basket of goods and services. It is the measure used for cost-of-living adjustments in many employment contracts and for Social Security payments.
Currently, the inflation picture looks tame, with most indicators remaining below the Federal Reserve’s 2% target, despite the differences in their compositions and the methodologies used to calculate them. In fact, inflation has averaged less than 2% since the end of the financial crisis in 2009 and the core inflation rate has barely budged above 2% for more than a few months at a time. But this has not always been the case. Many of you remember that over the 1970s, developed-world inflation averaged 10% a year. From the early 1970s to the 1980s more than 50% of Americans said “inflation or the high cost of living” was the single biggest problem facing the country.
Paul Volcker was the Federal Reserve chairman in the 1980’s who took bold and aggressive action to tame inflation. In fact, if you were a young adult during this time, you probably remember paying 15-18% interest when purchasing your first home! By the 1990’s, the beast of inflation was vanquished, and we have enjoyed a low inflationary environment for the last three decades.
At present, economic growth is picking up as the vaccine rollout gains speed. Commodity prices are heading higher, the government is proposing another large fiscal aid package, and the Federal Reserve is pledging to keep its very easy monetary policy intact for the foreseeable future. Not surprisingly, inflation expectations are rising, as illustrated in the chart below.
We expect to see an uptick in inflation over the next few months. The economy continues to recover, and the private sector will find itself flush with cash as people receive their vaccinations and get back out into the world. Households have very strong balance sheets at the moment and are sitting on vast amounts of cash and savings. There is a likely chance that people may go on a spending spree, making up for lost time in theaters, restaurants, stores and bars in 2020. This could result in a short-term spike in inflation.
That being said, we don’t think this will result in 1970’s style inflation because there is still economic slack existing. Plenty of people are out of work or underemployed as a result of the pandemic. It is more likely the economy will get back to speed in fits and spurts. On a year-over-year basis, inflation will likely tick higher. However, getting inflation to hold sustainably above the Fed’s 2% target for core CPI likely will take another year or two, considering the large output gap.
When we look a few years down the road, the case for a move up in inflation grows stronger. The Fed’s easy monetary policy stance combined with the prospect for another round of fiscal relief of about $1 trillion, igniting stronger demand, and a rebound in the economy as the vaccine rollout proceeds—could lay the groundwork for higher average inflation than we have experienced for the past decade.
What should investors consider now?
Here are a few things we are doing to prepare if inflation rises modestly, as we expect:
1. Keep average duration low. Duration is a measure of how long a bonds maturity is. Longer duration means a longer term on the bond. Bond prices and yield move in the opposite direction. When interest rates rise, the price of long-term bonds goes down. If interest rates rise in the future in order to combat inflation, long term bonds will likely go down in price. The important thing is to keep your duration short in the bond portfolio. We like to see it at 5 years or less. If you go too short, it is almost like cash. There is a sweet spot right around five years at the moment.
2. Consider TIPS. Treasury inflation protected securities, or TIPS, historically tend to keep up with inflation because they have such short maturities and can be rolled over frequently as the Fed hikes short-term interest rates. TIPS are designed to keep pace with inflation. They have a fixed coupon rate but receive an adjustment to the principal amount based on the inflation rate. Although the coupon rate remains fixed, the coupon payment rises with the rise in the principal. This provides the benefit of an income stream linked directly to inflation and the potential for more principal at maturity in a rising inflation environment.
3. Add more yield when appropriate. We do not expect extremely high inflation in the short term. When bond yields rise in the future you can opportunistically use this as a time to add medium term bonds to the portfolio. In past rising-rate cycles, long-term rates typically moved up before short-term rates, causing the yield curve to steepen until rates approach the expected peak in the federal funds rate. As the Fed begins to tighten policy by raising short-term interest rates, the yield gap narrows, and the yield curve flattens. Because long-term rates represent the average of short-term rates plus a risk premium (term premium), short and long-term yields tend to converge at market peaks. Often, investors wait too long to add more yield to portfolios. As a result, they can end up missing the opportunity to lock in those higher coupons. We suggest strategies like bond ladders or barbells (which divides the allocation between short- and intermediate-term bonds) to help “average in” to higher yields over time. Bond ladders are particularly useful because they help balance the desire for income today with tendency to want to time the market.
Looking across the bond market, it is important to understand how different sub-asset classes have performed in both low and high inflationary time periods. As the chart below shows, Treasury bills tend to perform well during high inflationary periods because maturities are shorter and the yields rise when the Federal Reserve hikes rates. Conversely, when inflation does not materialize and the Fed does not see a need to hike rates, Treasury bills offer little upside in yield. This is another reason why we like bond ladders and barbells: The investor does not “miss out” if inflation does not come to fruition.
Returns in high- and low-inflation periods
Note: Each return listed is for the full time period available for each of the asset class indices shown.
In conclusion, we do anticipate inflation picking up in the near to medium term (although we don’t see it getting as bad as the 1970’s). What else can you do to prepare for that? The best inflation fighter, some even call it the inflation killer, has been owning shares of the great companies of the world. Owning stocks has proven to significantly outpace inflation over long periods of time. While experiencing volatility (like we did last March) it is a small price to pay to be able to maintain the lifestyle you enjoy.
The key variable is to make sure you have properly accounted for inflation in your financial plan. Also, it is critical to look under the hood and understand the composition of your bond portfolio. Lastly, it is important to own shares of the great companies of the world and remain globally diversified to help manage through what the next 5 to 10 years bring us. As always, if you have concerns about inflation or want to discuss this with us, please do not hesitate to contact the office.