We’ve all heard the phrase, and sometimes used it ourselves, “a dollar does not buy what it used to”. The most common way we experience this is in the products we use every day. Just 30 years ago, we were lamenting gas prices over $1.00 per gallon. Today, gas prices routinely rise over $3.00 per gallon in most areas and even more in high population areas. And even though consumer prices have remained fairly stable over the past decade, you know that certain items at the grocery store, particularly consumer staples, cost more.
The reason for this is inflation. Inflation is a natural economic force that is influenced by market dynamics in a number of ways. In this article, we’ll review what inflation is, how inflation is measured, and what factors cause inflation to rise. We’ll also provide a brief description of deflation and how inflation affects different kinds of investments.
What is inflation?
Inflation is a general rise in the cost of goods and services which is offset by a symmetrical decline in the purchasing power of a currency. So to say a dollar doesn’t buy as much as it used to may be true, but it can become a bit more complicated of a story. Ideally, as economies grow, so do wages. An increase in wages sparks consumer demand, which in turn causes supplies to become scarce. The result, prices increase. So, while it’s true that a dollar doesn’t purchase as much as it used to, it’s also true that workers are making more than they used to so prices need to be viewed in a sense of if wages are keeping up with inflation.
Inflation creates a distinction between the nominal interest rate (which is the growth of your money) and real interest rates (the growth of your purchasing power). So if you receive a 5% increase in wages and inflation grows at a rate of 2%, you will find yourself with more purchasing power because your wages are increasing more than the rate of inflation. By contrast, if your wages are flat and inflation rises, your purchasing power is reduced because the growth of your money is not keeping up with inflation.
How is inflation measured?
Measuring inflation can be an imperfect science because different factors can influence the supply and demand for different items. To help offset this, the government (specifically the U.S. Bureau of Labor Statistics) conducts what amounts to two surveys using two price indexes. These are commonly referred to as the Consumer Price Index (CPI) and the Producer Price Index (PPI). The difference in the two indexes is obvious in their name. The CPI looks at price changes in consumer goods and services such as gas, food, and clothing from the point of view of the consumer (or purchaser). Approximately 80,000 items are included in the monthly CPI survey.
The PPI also measures changes in pricing for goods and services from the perspective of the producer. Each index measures the price of a number of goods that represent a “market basket” that is compared from the previous measuring period. Although the point of view is different, over time the PPI and CPI will show a similar inflation rate. However, in the short term, the PPI typically reports price increases faster than the CPI. Investors, however, tend to put more weight on the CPI.
What factors cause inflation to rise?
In reality, inflation is caused by a variety, and the combination of, market forces. However, the most common inflation “trigger” would be interest rates. The Federal Reserve Bank, which has significant influence over the nation’s monetary policy, has set a 2-3% rate of inflation as a target. To help achieve this target, the Federal Reserve meets throughout the year to set monetary policy for the country. The decision at these meetings that sparks the most interest is their decision to increase, decrease, or leave unchanged the Federal Funds rate. One of the measurements they look at is the inflation rate. If inflation appears to be increasing beyond the target rate, the Fed may look to raise interest rates to suppress demand. Conversely, if inflation is not reaching the target level, they may lower interest rates to spur demand.
This raises the question is some inflation good? The answer to that question is yes. Think of inflation as part of a healthy economy. If you work for a company that manufactures widgets, you will want consumers to buy your widgets. This not only keeps you employed, but it can cause your company to have solid earnings that may increase your wages. At the same time as your wages rise, the price of your company's widgets should increase as well. This is the good, healthy part of inflation. When the economy is slowing, if consumer prices rise, it will typically tip the economy into recession because consumers will look to save more or find cheaper alternatives to your company's widgets. The Federal Reserve’s role is to try and find a healthy, steady inflation rate that is supported by other macroeconomic factors.
Another factor that can cause inflation is when there is an increase in the money supply. One of the most extreme examples of this was the “quantitative easing” that the Federal Reserve undertook to provide liquidity to the financial markets during the financial crisis of 2007. In this case, although inflation was expected to rise, it has largely remained in check due to the extreme deflationary conditions that existed in the economy at that time.
What is deflation?
Once you understand what inflation is, it becomes easy to understand deflation. As you might expect, deflation is when prices for goods and service undergo a general decline. This happens when the inflation rate falls below 0%. In the United States, the most severe case of deflation occurred during the Great Depression. What triggered the deflation was the failure of banks and bank runs on others. This is due to the fact that deflation occurs when money is pulled out of a country’s financial system.
How does inflation affect different investments?
One of the goals of every investor should be to invest in securities that provide a rate of return that is greater than the rate of inflation. This is one reason why every investor needs to have a range of growth stocks in their portfolio. Even some of the most conservative stocks typically provide a rate of return that makes them an effective hedge against inflation. This doesn’t mean, however, that all stocks are safe. In some cases, inflation can have a disproportionate impact on a company’s earnings report. For example, if inflation is high, a company’s growth may be fueled by inflation rather than real revenue. So investors need to be certain to use due diligence when evaluating cash flow statements and balance sheets.
Yields on bonds, in contrast, while not falling (most bond yields are locked in at the time of purchase) will lose significant purchasing power if the inflation rate rises above the bond’s yield. When you purchase a bond, you are essentially lending money to the company or government entity that issues the bond. Inflation is a benefit to borrowers, but it does so at the expense of lenders. Before we give an example, it’s important to remember that inflation highlights the difference between nominal interest rates (which is the growth rate of money) and real interest rates (the growth of your purchasing power).
For example, if you invested in a 1-year Treasury bill with a 10% yield, you expect to receive $1,100 when it comes time to cash in the bond (10% of $1,000 = $100). However, if inflation was 3%, then your net return was only 7%. You’ll still receive $1,100, but the purchasing power of that $100 is actually $70.
This is a key reason why investors will flee bonds as inflation rises which will cause their yields to drop. Conversely, when inflation stays in check, bonds can become more attractive as their yields rise above the level of inflation. Treasury inflation-protected securities (TIPS) are a special kind of Treasury note or bond that ties the principal and coupon (interest) payments to the Consumer Price Index (CPI), so they will increase or decrease to offset inflation. TIPS are only a good investment in times of high inflation (i.e. inflation that exceeds the target inflation rate). This is because they offer a low rate of return, meaning the only benefit of owning them for investors is if inflation is high.
For commodity investors, inflation can be a benefit or an anchor on their investments. For the last decade, gold and precious metals have gained popularity as a hedge against inflation particularly as the U.S. had an expansionary monetary policy that was devaluing the dollar. Other commodities such as oil, soybeans, and wheat are hurt by inflation.
The bottom line on inflation
You don’t have to be an economics major to understand the role of inflation in our economy. Although prices have stayed fairly constant over the last 10 years, our country has gone through periods marked by high inflation.
Inflation is an effect that has several causes. In a healthy economy, a little inflation is very natural and is generally considered a positive sign as wages, employment, and prices tend to rise together. The U.S. Department of Labor Statistics surveys producers and businesses on a monthly basis. These surveys comprise the Consumer Price Index (CPI) and the Producer Price Index (PPI) that broadly reflect pricing changes due to inflation.
Although no single metric is said to cause inflation, interest rates and inflation have a direct correlation. The Federal Reserve monitors the CPI and PPI to see where inflation is relative to their nominal target of 2-3%. In 2017, inflation reached its target for the first time since the financial crisis of 2007 and signaled an end to the Fed’s program of quantitative easing that had increased the nation’s money supply (which can cause inflation in a healthy economy).
For stock investors, inflation does not hold much concern as quality stocks will generally yield a return that is beyond the rate of inflation. Income investors, who typically invest in bonds, are more affected by inflation since inflation lowers their real rate of return. A bond investor that gets a 10% yield on a 1,000 bond will find themselves with less purchasing power if inflation is at 5%. Effectively their $1,100 payout will only buy $1,050 of goods and services.