IN THE KNOW

What’s good about inflation?

Jul 7, 2021
  • Dennis Lee, Market Insights Lead

The investing world is abuzz with the news that the Consumer Price Index increased 5 percent from May 2020 to May 2021 – the highest increase since 2008. Inflation that high is typically bad for investments, as any returns lower than that are negative, in real terms.

Not everyone is panicking yet, though, because it’s just one month compared to another month in 2020, and the spike can largely be explained by pent-up consumer spending as life returns to normal in the U.S.

But it’s important to watch the inflation trend, as the U.S. Federal Reserve implements its policy of keeping inflation around 2% - a policy known as FAIT, or Flexible Average Inflation Targeting. 

Why inflation has been low 

First, the obligatory reminder inflation has been historically low. Since 1926, average inflation per year has been around 3%, and we’ve been under 2% for the last decade.

Consumer price index (CPI) as of May 31, 2021

Consumer price index (CPI) as of May 31, 2021

Source: Bureau of Labor Statistics as of May 31, 2021.

Why? Global competition, price transparency, and technology improvements have all depressed prices.

For example, the U.S. Bureau of Labor Statistics estimates that the price for TVs decreased by 94 percent from December 1997 to August 2015. Ever try to resell an old TV? Super difficult these days.

Of course, not everything has gone down in price. Hospital services, water & sewer services, the cost of beef and veal, of all things, have all surged in price more than 40% over the last 10 years. But you’ll notice that that list comprises things that generally have not been transformed by technology in recent decades (though that is quickly changing). College tuition has risen by 37.5% over the last ten years as well – and if you have a kid in college, you don’t have to be reminded.

So while inflation overall has been low, no one needs reminding that periods of higher inflation could be painful.

Why inflation can be good

Back to FAIT. A few weeks ago, BlackRock portfolio managers Jeff Rosenberg and Tom Parker wrote an article called “Tempting FAIT.”  Hard to believe that these guys are both premier investors in their field, as well as sublime headline writers. The article is worth the read, but I’ll do my best to summarize.

Critics of FAIT say that the policy is risky (hence, the Fed is tempting fate) because it could potentially result in runaway inflation, putting pressure on both investments and wages. So what is the Fed doing? 

Well, for one, deflation can certainly be bad. Let’s say a TV that costs $1,000 one year, and the next year a newer model costs $800. The theory goes that if prices overall are trending downwards, consumers will wait to make their purchases. TV manufacturers become sad, start making fewer TVs, and then start having to layoff their employees.

Another example: Under a deflationary scenario, over time, you’re likely to be paid less as the cost of living goes down, but your mortgage bill will stay the same. Debt becomes unsustainable.

The key then, is to keep inflation at a reasonable level, but not high in order to keep the economy thriving. Why 2%? In truth, it’s a bit arbitrary, as a “reasonable level” is essentially determined by what people have come to expect. And with the average hovering around 3% (with that average brought up by periods of hyperinflation in past decades), 2% has been the sweet spot, or what they refer to as “target inflation.”

If you’re curious, the Fed literally has a page called to “Why does the Federal Reserve aim for inflation of 2% over the longer run?” on their website.

Why staying balanced is not easy

The problem is that keeping that balance isn’t easy. Jeff Rosenberg and Tom Parker explain in their article that recent inflation could be fleeting because eventually, people will return to their normal spending behaviors.

What’s more concerning, however, is that wages increased as well, unexpectedly.

The graph below shows that about half of firms surveyed this year are planning on raising prices, with 60% having problems hiring – meaning wages may not go down any time soon.

Cost push inflation graph

Source: Bloomberg, National Federation of Independent Businesses (NFIB) survey data, as of June 8, 2021.

This is good for some individuals in the short-term, but bad for the inflation picture.

As wages go up, firms pass on higher prices to consumers, and a shortage of labor emboldens workers to demand higher wages. This cycle could lead to persistent rising inflation.

What should we do about inflation uncertainty?

Inflation puts pressure on bonds in particular, as real returns for bonds could be negative in this historically low rate environment. (Read more about the low rate problem.)

But inflation uncertainty is also likely to produce stock volatility as more data trickles in. Even if inflation is temporary, we could also see a louder chorus of debate on the Fed’s activities, adding to the volatility.

During past stock market selloffs, interest rates fell, causing bonds to rally (bond prices go up when interest rates fall). Today’s yields are so close to zero that there’s not much more room for those rates to fall. A traditional 60/40 portfolio might feel a little like investing without a parachute —where bonds no longer provide as soft of a landing when stocks sell-off.

But the sneaky beneficiary to all of this? Alternative strategies, perhaps. The opportunity set for alternative strategies, particularly ones that use long/short strategies, potentially expands because during periods of volatility they can go long on the winners and short the losers.

The returns of a 60/40 portfolio are based on market direction alone. And some alternatives are designed to thrive in a market of seesawing volatility.

The bottom line

Inflation can be good – particularly at target inflation.

But with greater inflation uncertainty expected in the coming months, and the looming possibility of it running away, most investors with traditional portfolios may find that they don’t have assets that are designed to thrive in that environment.

Advisors would do well to help their clients prepare their portfolios by considering alternatives that are designed to provide diversification to equities and protect against inflation over the long-term. 

Read more about potential solutions here.