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 margins.
Inflation can also be impacted by government or central bank policies. 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.
However, even modest inflation erodes purchasing power over the long-term. According to the Bureau of Labor Statistics, a dollar in 1990 was equivalent in purchasing power to $2.42 at the end of 2023. Even though inflation averaged only 2.62% during that period, a dollar lost well over half of its purchasing power.
$1 in 1990, Adjusted for Inflation
1990-2023
Source: Bureau of Labor Statistics
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.
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 June 30, 2022, inflation rose by 9.1%. This is less than in 1974, 1979, and 1980 when rates exceeded 12%, but it still represents a significant increase. The annual inflation rate fell back to 3.14% by November 2023.
This spike in inflation has been attributed primarily to causes related to the COVID-19 pandemic. As the economy opened up again, consumers 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 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 the future rate of inflation, 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 14, 2023, the spread between 10-year TIPS yield and the yield on the 10-year Treasury was 2.22%. That can be viewed as the market’s assessment of the future inflation rate as of that date.
Although the market’s estimate of future inflation is not a precise indicator, it has done a reasonably good job of tracking it. The graphic below shows how the market’s estimate tracked the actual rate of inflation from 2003 through 2018. Notably, it badly underestimated future inflation during the 2008 financial crisis and the post COVID inflation spike.
Inflation Expectations vs. Reality
2003-2018
Data source: Federal Reserve Bank of St. Louis.
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 all investment decisions, there are unique risk and return implications associated with each alternative.
TIPS: Treasury Inflation-Protected Securities
TIPS are one of the most often cited hedges against inflation. But 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.
Mixed Record as an Inflation Hedge
Annualized Returns
Source: Morningstar. Data as of June 30, 2020
In addition, 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 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.
For a more detailed review of gold as an investment vehicle, 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. As a result, even during periods of higher inflation, the stock market often performs well.
Some research suggests that value stocks may do better than growth stocks during periods of higher inflation. So, investors may wish to consider a tilt toward value stocks during periods of high inflation. However, there are certainly periods when this has not been the case and is no guaranty that past patterns will repeat during future inflationary periods.
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 bond holdings, they can reinvest those amounts at the new higher market rates. Depending upon the circumstances, they can make back any losses they experienced in a relatively short period.
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. 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 interests 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
The information contained herein does not constitute investment advice or a solicitation. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.