A few months ago when the Federal Reserve (The "Fed") began to describe the dramatic increases in prices for consumer goods and services, they described it as "temporary." I wrote a blog then ("Inflation - Should you Finally Be Concerned?") to address among other things, the use of the word "temporary" when prices had been rising since February and the supply chain bottlenecks were foreseeable due to the effects of COVID19. But the Fed was simply practicing an essential objective when it comes to addressing inflation - temper the expectations. Actual inflation is secondary to the expected inflation of consumers. If consumers expect prices to increase, they may hold off on purchasing discretionary items in favor of needing more for essential items. If companies expect prices to increase, they may slow down production which means potential layoffs, or they pass on the higher prices, which may only compound the problem. During the Fed's last meeting (November 10), the outlook was no longer considered "temporary."
The chart below illustrates the longer-term increases in inflation so far this year.
Consumer Price Index - Urban (CPI-U)
The Fed's inflation outlook has been modified to expectations of having higher than normal inflation well into 2022. Inflation is mainly seen as a negative consequence because of the potential loss of purchasing power that a consumer loses. For example, If inflation is 5% a year for 3 years, the same items costing $100 today will cost $115.76, and in 10 years those same items will cost $162.89. If your after-tax income and investment returns are less than inflation each year, you are losing purchasing power. Longer periods of high inflation can erode growth and accumulated asset values.
Why the sudden inflation?
The sudden rise in prices is indisputably due to COVID 19. One company after another was either shutting down or drastically reducing operations during 2020. We were not prepared to handle the surging demand brought about by quick lump-sum payments from government stimulus and the gradual reopening of our economy. It has taken a while for companies to restart their operations due to supply bottlenecks of materials and a decreasing labor pool. People want to spend, they just have a limited supply of things to buy. With the holiday season upon us, and a gradual loosening of supply constraints across the globe, we should have continuing strong demand that will likely result in more price increases.
What can stop the rising prices?
According to economic theory, prices of things are based on the demand and supply for those things. An increase in demand for a good or service, given unchanged supply, will tend to increase the price. A shortage of that item, given unchanged demand, will also increase the price. What we are experiencing is an increased demand and a supply shortage concurrently! To get a handle on the demand/supply relationship, the Fed will attempt through monetary policy to regulate the supply and demand of our most valuable commodity - money. To have prices decrease, either the demand for money must slow down and/or the supply of money must be tempered.
The monetary policies employed by the Fed to try and slow down the demand for money is to raise borrowing rates that member banks charge each other (fed-funds rate). To decrease the supply of money, the Fed will sell some of their holdings of government and corporate bonds (withdrawing cash from economy), or by increasing reserve requirements of member banks - lowering supply of loanable funds. The desired effect is to raise borrowing costs for banks, who will charge their borrowers a higher rate and so on....a chain reaction. Raising rates will reduce lending and spending activity – an effective tool for combating price increases but not a great strategy for maintaining economic growth. Lower demand usually means lower production, higher unemployment, and may signal an economic recession..
Deflation describes a reduction in prices. That sounds ideal during a time when inflation is growing at a rapid pace, but it can also come at a price. For prices to decrease, either the supply of money and credit is reduced or consumers stop buying. Considering that the Fed is currently injecting approximately $1.2 billion dollars a month into the economy through bond purchases (they print money and loan it) and interest rates remain historically low, materially reducing the money supply is not likely to happen in the next few months.
Disinflation describes the slower pace of increases in the inflation rate. This situation isn’t as problematic since prices are still rising, just not as fast as the higher previous pace. For example, the inflation rate according to CPI for Oct 2021 for earlier 12 months was 6.2%. Assume that the rates for the next few months begin to decline to 4.5% by June. There is still inflation, but not growing as fast as before.
What does the Fed plan to do?
So far the Fed has not employed any traditional monetary policy actions to slow down the rate which has been moving upwards since February. They have intimated that they will be reducing the $1.2 billion-dollars-a-month by $150 million each month beginning in November 2021. By mid-June of 2022, the bond purchasing is expected to completely cease, and then there will be discussion on raising interest rates if needed. Considering that the level of interest rates have been historically low since the Great Recession of 2008, the Fed is acutely aware of the potential negative effects of rising interest rates and would like to avoid this step. However, there are many retirees who would love to get more interest on their cash savings and avoid higher-risk investments to simply keep up with inflation.
What investments are suitable in periods of rising inflation and interest rates?
Forecasting economic expansions and recessions are hard enough, but then trying to forecast how the markets react to the economic conditions is costly, time-consuming, and most times counterproductive (because of the costs). There is an ample amount of evidence that demonstrates that the chances of positive returns dramatically increase as the length of time elapses. For example, the U.S. Stock Market's annualized rate of return from 1941 - 2020 was 11.50%. Along the way, there have been numerous economic cycles and periods of high inflation and interest rates. Disciplined to your financial goals is the most effective path and maintaining discipline through up and down markets is essential to capture the long-term benefits of compounded growth. However, the knowledge of how equities generally respond to inflation is important to understand.
Past Performance is no guarantee of future value
The stock market does not like inflation because it means the costs of labor and materials for companies will likely increase, which may impact the bottom line. Higher interest rates can increase borrowing costs for highly-leveraged (a lot of debt) companies that can lower the bottom line. However, the company has the option to offset higher costs by passing the increased costs to the consumer in the form of higher prices. It is then the consumer who ultimately feels the bite of inflation. The stock market will factor in this possible reduction in consumer demand in its daily stock valuations. During periods of rising prices, there is typically steady demand for essential items (groceries, gas, health, etc.) and less on more discretionary items (appliances, automobiles, travel, etc.).
The bond market is where rising inflation can have the most impact because the bond yields are linked to interest rates, and interest rates are strongly linked to inflation, or more specifically, expected inflation. When an investor purchases a bond, they are essentially lending money and they are entitled to interest payments during the term of the bond and principal repayment at the maturity of the bond. The two main factors when evaluating bond investments is the issuer's credit quality and the length (maturity) of the bond. A potential bond investor should ask the following question:
"Do I believe that interest rates will increase, stay the same, or be reduced in the future?, and "how long of a term should I lend the money?"
If I believe that rising prices in the future indicate potentially higher future interest rates, then I would probably prefer to lend money for shorter maturities (no greater than two years) rather than longer ones because I can “roll over” the bond into higher-yielding bonds during rising interest rates. The U.S. Treasury issues debt instruments (bonds) that have maturities from 3 months to 30 years. Other bonds such as corporate bonds or municipal bonds have longer maturities (average of 10-year maturities).
Treasury Inflation-Protected Securities (TIPS)
Inflation-protected securities (TIPS) are debt securities (bonds) issued by the U.S. Treasury whose principal and interest payments are adjusted for inflation, unlike conventional debt securities that make fixed principal and interest payments. A TIPS is a bond sold at auction that receives a fixed stated real rate of return but also increases its principal according to the changes in inflation, as measured by the non-seasonally adjusted U.S. Consumer Price Index for All Urban Consumers (CPI-U).
As an appropriate analogy, think about adjustable-rate mortgages – the adjustable rate will increase if interest rates in general, are rising. Well, inflation protection securities will compensate the holder for rising inflation. The original rate at purchase will be the nominal rate (rates for conventional non-adjusting bonds) less the expected inflation rate, which is the real return. It is unexpected inflation that will make these securities generate higher yields than their conventional counterparts.
How Do TIPS Work?
For example, a $1,000 TIPS with a stated real interest rate of 2.50 percent would provide $25 a year interest (two semiannual payments of $12.50) and $1,000 back at maturity (average 10 years). Let us assume that a similar U.S Government bond with the same maturity (assuming both have no risk of default) is offering a nominal rate of 4%. What these rates indicate is that investors expect inflation to be approximately 1.5% a year (4% nominal rate less 2.5% real return).Now let’s assume that the following year, inflation actually increased 3.0% and not the expected 1.50%:
The math would work as follows:
First, the adjustment to principal is calculated based on actual inflation. Thus, the principal would rise from $1,000 to $1,030, an increase of 3 percent (actual inflation rate). Second, the interest payment of 2.50% would be calculated from the new principal of $1,030 (instead of the bond face value of $1,000 as conventional bonds). The new annual interest rose to $25.75 compared to $25.00 and the amount due at maturity is now $1,030 instead of $1,000. Negative inflation will not lower the value of the security or decrease interest payments.
The potential downside of TIPS is that the expected inflation does not occur. I have been recommending TIPS to clients since the Great Recession of 2007 – 2009 in anticipation of higher interest rates but of course, inflation, or at least reported inflation, has been very minimal historically. What happens with no reported inflation is that the real rate of return will remain below what could have been received by a comparable nominal return bond (10 yr.). Also, if interest rates rise without accompanying inflation, the value of the TIPS will fall (only material if you plan on selling TIPS before maturity).
Although not a perfect hedge against inflation, hard assets such as real estate can buffer losses in purchasing power since it is the hard assets themselves that are most likely increasing in price. Examples include real estate investments - either through public investment (REIT’s) or private ownership. Commodities (agriculture, gold, silver, etc.) are tangible assets whose value may rise during inflationary periods but be aware that commodities are speculative investments (not based on earnings of companies, or the credit quality of borrower).
** All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss.
Carr Wealth Management, LLC is an independent fiduciary serving clients with knowledge based solutions. We help clients reach financial objectives and goals using low-cost and efficient strategies including an emphasis on client education. Anthony Carr has been a CPA for the past 34 years and a CFP practitioner for twenty-four years. The company prides itself on not only helping clients make the right decisions, but also helping clients avoid the wrong ones! Please contact us for a no-charge consultation or let us know if you have a question.