Persistent deflation can increase unemployment and undermine the financial system as well as the broader economy by making it more difficult to service debt. The U.S. Federal Reserve is targeting a 2% average inflation rate over time as most consistent with its dual mandate to promote price stability and maximum employment.
Sharp deviations from a modest inflation rate in either direction present challenges for investors as well as consumers. That's because they have the potential for significant economic disruption. They also have varying and often unpredictable effects on various asset classes.
The Basics of Inflation
In economics, inflation is a quantitative measure—one of quantity over quality—tracking the rate of change in prices of a standardized basket of goods. Inflation is defined as an increase in prices over time, and the rate of that increase is expressed as a percentage.
The most common economic reports used to measure inflation are the Consumer Price Index (CPI), the Producer Price Index (PPI), and the Personal Consumption Expenditures Price Index. The PCE Price Index is the Federal Reserve's preferred inflation gauge. The PCE is a broader measure than the CPI and is weighted based on consumption measures used to derive the gross domestic product rather than on a household spending survey as the CPI.
CPI measures the weighted average urban consumers pay for a standardized market basket of goods and services. It is reported monthly by the Bureau of Labor Statistics (BLS).
PPI is a weighted average of prices realized by domestic producers. It includes prices from the first commercial transaction for many products and some services. It is also reported monthly by the BLS.
The PCE Price Index is a broader measure than the CPI of the change in the price of goods and services purchased by consumers. It is released monthly by the Bureau of Economic Analysis of the U.S. Department of Commerce.
All three of these indices provide an alternative "core" reading excluding the more volatile food and energy prices. Another alternative inflation measure is the Trimmed Mean PCE Price Index from the Federal Reserve Bank of Dallas, which excludes from each monthly calculation spending categories with the most extreme price moves in either direction.
How Inflation Affects Asset Values
While inflation's effects on the economy and asset values can of ten be unpredictable, history and economics offer some rules of thumb,
Inflation is most damaging to the value of fixed-rate debt securities, because it devalues interest rate payments as well repayments of principal. If the inflation rate exceeds the interest rate, lenders are in effect losing money after adjusting for inflation. This is why investors sometimes focus on the real interest rate, derived by subtracting the inflation rate from the nominal interest rate.
Longer-term fixed rate debt is more vulnerable to inflation than short-term debt, because the effect of inflation on the value of future repayments is correspondingly greater, and compounds over time.
The assets that fare best under inflation are those assured of bringing in more cash or rising in value as inflation increases. Examples would include a rental property subject to periodic increases in rent or an energy pipeline charging rates tied to inflation.
Real estate is a popular choice because it becomes a more useful and popular store of value amid inflation while generating increased rental income.
Investors can buy real estate directly or invest in it by buying shares of a real estate investment trust (REIT) or specialized fund.
Real estate fared particularly well during an outbreak of persistent inflation during the 1970s.3 But real estate is also vulnerable to rising interest rates and financial crises, as seen in 2007-2008. And interest rate increases are the conventional monetary policy response to elevated inflation.
When inflation picks up investors often turn to tangible assets likely to rise in value.
For centuries, the leading haven has been gold—and, to a lesser extent, other precious metals—causing price to rise as inflation rises. Gold can also be purchased directly from a bullion or con dealer or indirectly by investing in a mutual fund or exchange traded fund (ETF) that owns gold. Investors can also get exposure to a commodity by buying the shares of its producers directly or indirectly through an ETF or specialized mutual fund.
Many investments have been historically viewed as hedges—or protection—against inflation. These include real estate, commodities, and certain types of stocks and bonds.
Commodities include raw materials and agricultural products like oil, copper, cotton, soybeans, and orange juice. Commodity prices tend to rise alongside the prices of finished products made from those commodities in inflationary environments. For example, higher crude prices elevate the price of gasoline and transportation. Sophisticated investors can trade commodities futures or the shares of producers. On the other hand, exchange-traded funds investing in commodity futures will tend to underperform the price of a rising commodity, because their futures positions must be rolled as they expire.
Investing in bonds may seem counterintuitive as inflation is typically harmful to fixed-rate debt. That's not the case for inflation-indexed bonds, which offer a variable interest rate tied to the inflation rate. In the United States, Treasury Inflation-Protected Securities (TIPS) are a popular option, pegged to the Consumer Price Index.
When the CPI rises, so does the value of a TIPS investment. Not only does the base value increase but, since the interest paid is based on the base value, the amount of the interest payments rises with the base value increase. Other varieties of inflation-indexed bonds are also available, including those issued by other countries.
Inflation-indexed bonds can be accessed in a variety of ways. Direct investment in TIPS, for instance, can be made through the U.S. Treasury or via a brokerage account. They are also held in some mutual funds and exchange-traded funds. For a more aggressive play, consider junk bonds. High-yield debt—as it's officially known—tends to gain in value when inflation rises, as investors turn to the higher returns offered by this riskier-than-average fixed-income investment.
Stocks have a reasonable chance of keeping pace with inflation—but when it comes to doing so, not all equities are created equal. For example, high-dividend-paying stocks tend to get hammered like fixed-rate bonds in inflationary times. Investors should focus on companies that can pass their rising input costs to customers, such as those in the consumer staples sector.
Leveraged loans are potential inflation hedges as well. They are a floating-rate instrument, meaning the banks or other lenders can raise the interest rate charged so that the return on investment (ROI) keeps pace with inflation.
Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs)—structured pools of mortgages and consumer loans—respectively, are also an option. Investors do not own the debts themselves but invest in securities whose underlying assets are the loans.
MBS, CDOs and leveraged loans are sophisticated, somewhat risky (depending on their rating) instruments, often requiring fairly large minimum investments. For most retail investors, the feasible course is to buy a mutual fund or ETF that specializes in these income-generating products.
Pros and Cons of Investing for Inflation
There are pros and cons to every type of investment hedge, just as there are pros and cons with every type of investment. Also, there are positive and negative features to the various assets described above.
The primary benefit of investing during inflation, of course, is to preserve your portfolio's value. The second reason is that you want to keep your nest egg growing. It can also lead you to diversify, which is always worth considering. Spreading the risk across a variety of holdings is a time-honored method of portfolio construction that is as applicable to inflation-fighting strategies as it is to asset-growth strategies.
However, the inflation tail should never wag the investment dog. If you have specific goals or timetables for your investment plan, don't swerve from them. As an example, don't weigh your portfolio too heavily with TIPS if it requires significant capital appreciation. Also, don't buy long-term growth stocks if your need for retirement income is imminent. An obsession with inflation should never get you out of your risk-tolerance comfort zone.
There are no guarantees. Traditional inflation hedges don’t always work, and unique economic conditions sometimes deliver excellent results to surprising assets while leaving what seemed to be sure winners trailing in the dust.
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