Managing Inflation Risk

Managing Inflation RiskManaging Inflation Risk


Inflation is an economic term used to describe a sustained rise in the overall price level of goods and services within an economy. Over the long term, inflation can become an obstacle to reaching one’s financial goals. Consumer prices have remained stable for a long time, recent inflation reports range from subdued to trending downward in some regions, and energy costs have fallen, so why would investors worry about inflation at a time like this? While not necessarily an immediate threat, the most dangerous characteristics of inflation are that it can happen very quickly, strike unexpectedly and be detrimental to the value and performance of an investment portfolio.

Inflation is the one form of taxation that can be imposed without legislation.

– Milton Friedman, Economist Nobel Prize Winner

Simply put, inflation risk for investors is the possibility that a dollar tomorrow will be worth less than a dollar today. In other words, it will require more dollars to buy the same carton of milk if you wait to buy it tomorrow instead of today. This is also referred to as a decline in real purchasing power.

While a thoughtfully constructed and well-diversified portfolio is the best defense against most market dislocations over the longer term, inflation risk becomes more relevant in times of economic expansion, and especially in the wake of monetary stimulus programs. As investors’ time horizons may not allow them to ride out temporary pullbacks in their portfolios, or as imminent retirement plans may make preserving purchasing power of utmost importance, investors would be well advised to consider the prudence of including inflation hedging elements in their portfolios.

Defining inflation

Inflation can be good for an economy because it creates a slight urgency to purchase goods and services today before prices rise tomorrow. If inflation is gradual, supply is able to adjust to meet increasing demand, resulting in economic growth overall. On the other hand, inflation can be bad if the upward changes in prices happen so rapidly that the market is not able to adjust to a new equilibrium.

In the U.S., the general price level of goods and services is usually measured by the consumer price index (CPI) which the U.S. Bureau of Labor Statistics defines as “a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.” The rate of increase, or “inflation,” of this measure of the cost of living in the U.S. is usually of greater concern than the level itself since consumers are generally able to adjust to gradual increases but may be very negatively impacted by sharper increases, or short term spikes, particularly if wages and income do not increase at the same pace.

Inflation data are used for several purposes, of which the most relevant for investors is that, according to the Bureau of Labor Statistics website, “the President, Congress, and the Federal Reserve Board use trends in the CPI to aid in formulating fiscal and monetary policies.” In this respect, inflation is often reported as “core” and “non-core.” In an effort to smooth out the seasonality of the numbers and more effectively isolate an identifiable trend, discussion is often focused on core inflation, which includes everything except food and energy, which are traditionally subject to more volatile prices and occasional price shocks. Beyond general core-CPI trends, the Federal Reserve uses its own preferred measure of inflation called the personal consumption expenditures index (PCE).

Levels of Inflation

There are five levels of price inflation which indicate graduated degrees of economic severity.  Creeping inflation is defined as 3% or less per year. Mild inflation is generally 2% or less and can actually be beneficial to economic growth. Mild inflation creates urgency, but not panic, for consumers to buy goods and services before prices rise. Increasing demand drives economic expansion, so, in times of economic normalcy, the Federal Reserve Board will generally maintain a targeted level of inflation of 2%.  Walking inflation is defined as 3-10% per year and can be harmful because it can cause demand to outpace supply. When suppliers and wages cannot keep up, consumers can get priced out of markets. Running inflation is less clearly defined, but is often thought of as ranging between 10-20% per year. Galloping inflation is defined as over 20%. At these high levels, a country’s currency can quickly lose value in the global marketplace. Foreign investors and lenders who might normally invest in a particular country might instead avoid doing so, starving that country’s capital markets which the country’s businesses need to function and grow. Hyperinflation is defined as over 50% a month. This condition is very rare, and most examples cited involve governments printing money either recklessly to fund war or to recover from it – Germany in 1920’s, Hungary in the 1940’s, Zimbabwe in 2000’s and the U.S during the Civil War.

The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.

– Ernest Hemingway

Economists often discuss values in nominal and real terms. “Nominal” values can be thought of as face value while “real” values are nominal values that have been adjusted. For instance, the nominal value of a good may be its current market price, while the real value of the good is an indication of the good’s purchasing power. Prices from different historical periods are often adjusted for inflation to be able to compare in common terms. As inflation represents an increase in the nominal, but not in real, value, it is bad for bonds since it decreases the real value of the bond as well as the purchasing power of the coupon payments investors receive. In other words, in an inflationary environment, subsequent coupon payments become less and less valuable because their purchasing power decreases. For equities, inflation is less of a direct issue, especially if companies are able to pass additional costs on to consumers, benefiting their profits. However, in the long run, inflation can slow economic growth, which can negatively impact companies’ profits and the value of their equities.

Sources of Inflation

Economists generally categorize the sources of inflation into one of four types – decrease in the aggregate supply of goods and services, increase in the aggregate demand for goods and services, increase in the supply of money, or decrease in the demand for money. Cost-push inflation describes the condition in which the rising price of any of the four factors of economic production – labor, capital, land or entrepreneurship – causes the aggregate supply of goods and services to decline. Cost-push inflation causes costs of production and supply to increase – e.g. raw materials, higher taxes, etc. When companies are unable to pass on additional costs to customers, or hedge against increases, and if they are unable to raise the prices of the goods and services they sell, then their profits will decline. For some companies, reduced profits may stymie growth. For other companies, it may render their business unprofitable and cause them to exit the business. Overall, this type of inflation can derail an economic recovery or cause an economy to contract or go into recession.

Conversely, demand-pull inflation results from an increase in the demand for goods and services which may come from any of four main sections of the macro economy – households, businesses, government, or foreign buyers. This type of inflation is generally associated with lower unemployment and an expanding economy.

Increases in the supply of money, such as that following quantitative easing programs and other simulative government programs, often lead to inflation as they increase the monetary base and grow the broader money supply. The Federal Reserve aims to control the supply of money, and by extension, inflation. Such changes are policy driven and are not the product of economic fundamentals.

The demand for money, however, is driven by consumers. When prices appear to be increasing, people want to spend and get the most value for their dollar because the purchasing power of each dollar is depreciating.

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth. It will not produce perfect stability; it will not produce heaven on earth; but it can make an important contribution to a stable economic society.

– Milton, Friedman, The Counter-Revolution in Monetary Theory (1970)


Economists refer to a decrease in the price level of goods and services as “deflation,” which is indicated by the inflation rate falling below 0%. This can follow, but is distinctly different from “disinflation” which is the declining of the inflation rate to lower, but still positive, levels. While deflation may seem ostensibly positive, the risk to the overall economy is that deflation increases the real value of debt. Furthermore, if prices are falling, consumers may be inclined to delay purchases, which reduces economic activity overall as suppliers produce less to match a lower level of demand. This can spur a vicious cycle in which lower prices result in lower demand, which suppliers respond to by decreasing supply and lowering wages, which further lowers prices, and so on. This condition, sometimes referred to as a “deflation spiral,” can, in its worst form, derail a recovery and potential for growth for an entire economy.

Historically, the U.S. economy has seen four major deflationary periods – during the depression of 1818-21, during the depression following the Panic of 1837, during the Great Sag of 1873-96 following the Civil War, and between 1930-33 during the Great Depression – but hasn’t been severely crippled by this condition in almost a century. Since its creation in 1913, the Federal Reserve System and effective management of monetary policy has largely protected the U.S. economy from major deflation. Since the abandonment of the gold standard and adoption of the Bretton Woods System in 1948, the U.S. has seen only one significant period of deflation, 2008-9 during the Financial Crisis. Prices dropped, largely tied to declining energy prices, and on January 1, 2010, the state of Colorado became the first state to decrease the state minimum wage since the federal minimum was adopted in 1938.  As one of 10 states which tie the minimum wage to inflation, a provision of its passage was that wages could also fall with the state’s consumer price index, which decreased 0.6% in 2009.

Extraordinary monetary easing in the developed countries has raised fears in some circles that high inflation would be the result. Now, with inflation nearing zero in many countries, deflation is emerging as the greater concern. High debt burdens, slow growth, and now falling commodity prices have all played a role in suppressing inflation in Europe and Japan. In the United States, several factors are likely to keep inflation low for several more quarters, but deflation seems unlikely.

Looking ahead

Since the implementation of the quantitative easing programs began in 2008, the Fed has added $4.5 trillion in bonds to its balance sheet. The concern has been that the massive amount of liquidity added to the financial system through quantitative easing will eventually lead to inflation. (In quantitative easing the central bank buys bonds and pays for them by crediting banks’ reserve accounts — in effect by printing high powered money which can be lent out and can further increase money supply through a multiplier effect.)  So far that has not happened, and U.S. inflation appears subdued (Exhibit 1).


Exhibit 1: U.S. inflation remains subdued

Managing Inflation Risk

Much of the liquidity has remained on bank books as excess reserves, and slack in the economy has dampened wage and price pressures. Moreover, the bond market expects inflation to remain under control. The long-term expected inflation rate implied by the difference in yields on nominal 10-year Treasury bonds and 10-year TIPS is currently just 1.70% (as of February 13, 2015), suggesting that inflation will only be 1.7% for the next ten years. Fed officials are confident they can withdraw liquidity from the system quickly should inflation pick up. However, critics are not so sure.

As mentioned earlier, the U.S. Federal Reserve prefers to use the personal consumption expenditures price index (PCE), which includes a broader range of expenditures relative to the CPI. While the CPI uses data from consumer surveys, the PCE uses data from business surveys, which tend to be more reliable. It  also incorporates a formula which adjusts for short-term changes in consumer behavior that are not accounted for by the CPI. The PCE has been below the Fed’s 2% target for an extended period, 33 months at the end of the first quarter 2015. A comparison of the CPI and PCE are shown in this chart from the Wall Street Journal in Exhibit 2.

Exhibit 2:  CPI inflation vs. PCE inflation

Managing Inflation Risk

In the United States, several factors are likely to keep inflation low for several more quarters. First, despite the decline in the unemployment rate to 5.5%, real GDP (nominal GDP which has been adjusted to reflect the effects of inflation) is still 2.4%, below its long-term potential as estimated by the Congressional Budget Office. Second, wage growth remains lower than is usually the case at this stage of the business cycle. Third is the recent decline in oil prices which should affect consumer prices directly, but also are leading to reduced long-term inflation expectations (Exhibit 3).

Exhibit 3: Expected long-term inflation is falling

Managing Inflation Risk

The main reason inflation has not increased is that an enormous amount of slack has existed in the global economy. Slack refers to the difference between the economy’s potential capacity to produce and its actual level of output. In the United States, the pace of the current recovery has lagged past recoveries, but the unemployment rate, which was rising when the Fed began its first quantitative easing program and eventually reached 10%, has since fallen to 6.1%. In other words, the slack in labor markets is now smaller, suggesting that the likelihood of a pickup in inflation has risen.

However, the oil price shock in 2014 saw the price of Brent Crude oil plummet from over $100 at the beginning of 2014 down almost to $50 in the first few weeks of 2015. As a major input of the economy, drastically lower oil prices sharply reduce the costs of production. This gives investors reason to believe inflation would remain at bay.

Wage inflation and unemployment

U.S. wage growth has been slow since the recession. YOY wage growth was strong in 2007, but then dropped precipitously when the Great Recession hit in 2008, and has since begun to improve as the economy has gotten stronger. As shown in Exhibit 4, though unemployment is nearing pre-recession levels, wage growth is significantly lower. Policymakers are watching labor markets closely because it is unlikely that price inflation could take off without wage inflation. Labor costs, after all, are about 70% of corporate costs. Wages are rising, but at a rate no faster than at the trough of the recession five years ago. Wages did not fall during the recession, so employers have not needed to raise wages much to attract workers since then. As a result, slow wage growth may be a misleading indicator of slack in labor markets.

Exhibit 4: Wage growth has been slow in the recovery

 Managing Inflation Risk

Eventually, however, a tipping point may be reached when the pent-up wage deflation is absorbed, and employers will have to offer more money to fill positions, and a spike in wage demands may occur as growth picks up.  This appears to have happened in the United States in the 1930s, the last period of sustained recovery from a severe financial crisis and economic contraction.1

1See Michael Feroli, “Pent-up wage deflation: lessons from the Great Depression,” JP Morgan Global Data Watch, September 12, 2014.

The Congressional Budget Office estimates that the U.S. economy is currently operating at about 4% below its full-employment potential. This is below the 7.2% potential GDP gap reached in the third quarter of 2009, but still large enough to make the development of a wage-price spiral appear to be many quarters away. Success in avoiding inflation, however, ultimately rests with the Federal Reserve. Fed officials are confident that they have the tools to nip any unwelcome rise in inflation in the bud. Skeptics are not sure that the enormous amount of liquidity added to the financial system since 2008 can be removed easily or quickly.

 Inflation risk to portfolios

For investors, the risk is that inflation may negatively affect the performance of a group of investments in a variety of ways. Stifled economic growth suppresses asset appreciation and renders companies less able to service their debt, and less likely or able to pay or support their dividends.  Retirees who rely on payments from social security or bonds find this income worth less in an inflationary environment. For those close to retirement, it may be the risk to one’s ability to retire as planned, especially if the individual’s personal liabilities and living costs are rising simultaneously.

The greatest danger of inflation is that it can happen unexpectedly and come on faster than investors can move to protect themselves. That is why it is widely believed that a well-diversified portfolio should always include some sort of inflation protection, even if the risk does not appear to be imminent. However, hedging too much against one source of inflation risk may inadvertently alter the overall risk/return of the portfolio, and there is no universal answer for all investors. Therefore, investors must carefully consider their risk tolerances, investment horizons and tradeoffs when determining the type and how much inflation protection is appropriate.

Potential hedges

In essence, the most effective hedge against inflation risk is to own the goods and services for which prices are increasing. Several types of assets are generally considered to be the most effective inflation-hedges, among them gold and precious metals, commodity futures and commodities in general, real estate and other hard assets. As shown in Figure 1, over time, certain commodities have proven to hedge against inflation more effectively than others. Energy has historically been the best hedge against inflation; however, it is also the most volatile. Agriculture and livestock commodities, on the other hand, tend to be less effective. It is also debatable whether precious metals, including gold, are as effective as people generally believe. In many ways, gold is more effective in hedging against geopolitical risks.

Figure 1. Regression Results for the Inflation Hedging Property illustrating the hedging properties of each commodity from 1983 to 2007.

Managing Inflation Risk

One thing to note about investing in commodities is that it can be tricky if one is not entirely familiar with the complexities of the individual markets. Issues to consider include storage costs for holding commodities directly, or roll costs/benefits for investing in commodities through derivatives.

Real Estate has proven to be effective in hedging against inflation for a couple of reasons. In general, the industry is highly leveraged, meaning real estate companies tend to hold very high levels of debt in the form of long term fixed mortgages. As discussed earlier, debtors benefit from inflation because it decreases the real value of what they actually owe in terms of purchasing power. Additionally, some Real Estate Investment Trusts (REITs) are well positioned to benefit in an inflationary environment – those with long term fixed mortgages and short term rents such as hotels or apartments that have the ability to increase rents at or above the pace of inflation.

Historically inflation has been the biggest driver of bond yields, which moves inversely with bond prices. However, within  fixed  income,  Treasury  Inflation-Protected  Securities  (TIPS)  and  inflation-linked  bonds  offer  some protection against inflation, along with short term bonds, which can provide protection against inflation by lowering the real return volatility of a portfolio.  The principal portion of TIPS increases with inflation and decreases with deflation, as measured by the Consumer Price Index, and, TIPS generally trade with less volatility than real assets.  TIPS mutual funds, however, generally have longer durations, so if interest rates rise, this could negatively impact the price of the funds as bond prices move inversely with interest rates.

On the equity side, it is a widely debated subject whether equities in fact provide a hedge against inflation, and within equities, which sectors or industries are most effective. Provided inflation remains tame, Jeremy Siegel asserts that “stocks will act as an excellent hedge. The reason is simple: Stocks are claims on real assets, such as land and plant and equipment, which appreciate in value as overall prices increase.” However, over the shorter term, higher inflation can quickly begin to erode these returns. In general, over any time period, companies that can quickly adjust prices upward and keep expenses from rising as quickly could actually benefit from inflation, as would stocks with high correlations to inflation beneficiaries such as commodities, real estate, and mining of metals, etc. Additionally, larger, global companies generally maintain greater pricing power in their markets and are diversified across international geographies which provide a greater array of options to combat inflation.

Investment in commodities and commodity-index-linked securities may be affected by overall market movements and other factors that affect the value of a particular industry or commodity, such as weather, disease, embargoes, or political and regulatory developments.

Investment in REITs are subject to additional risks such as illiquidity and property devaluation based on adverse economic and real estate market conditions.

Treasury securities are backed by the full faith and credit of the US government as to the timely payment of principal and interest. The principal value will fluctuate with changes in market conditions. If they are not held to maturity, they may be worth more or less than their original value.

Investing in mutual funds is subject to risk and potential loss of principal. There is no assurance or certainty that any investment or strategy will be successful in meeting its objectives. Investors should consider the investment objectives, risks and charges and expenses of the fund carefully before investing. The prospectus contains this and other information about the funds. Contact your registered representative or the issuing investment company to obtain a prospectus, which should be read carefully before investing or sending money.


There are many reasons to believe that inflation risk does not pose an immediate threat – among them slack in the economy, stability in the velocity of money, lower oil prices, and subdued long term inflation expectations in the bond market. However, history has shown the devastating effects inflation can have on portfolio returns, and there are an increasing number of reasons to believe inflation may be drawing nigh. Much like any sort of insurance, the best time to purchase is when it doesn’t appear necessary.

Investors must individually identify and assess the costs and benefits of hedging against specific risks, including inflation. There is no universally appropriate answer regarding how best to protect a portfolio again inflation, as much depends on the investor’s time horizon, risk tolerance, and existing investments. Thus, investors would do well to understand the nature of the inflation risks they are looking to hedge against, the options they have do so, and when (and when not) to hedge against inflation.

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