It’s still not clear whether inflation is making a permanent comeback in 2021, but it’s started to receive a lot of news coverage. Near-zero interest rates, pent-up demand, and aggressive governmental stimulus are considered by many to be key ingredients for a rising inflation scenario. So how concerned should we be?
How Inflation Is Measured
The US Bureau of Labor Statistics monitors inflation on a monthly basis using the Consumer Price Index, or CPI. While this is not the only measure of inflation, it is the most broadly used: CPI provides the basis for cost of living increases for Social Security payments and many companies’ pay raises. The CPI tracks changes in cost across eight major spending categories compared to 12 months earlier (Figure 1).
Figure 1 – Spending Categories Included in the CPI
Source: Bureau of Labor Statistics
CPI inflation has remained low for the past 20 years, averaging 2.1% annually (Figure 2). Negative readings (deflation) occurred during the Great Recession – meaning consumer prices trended lower. So in this context, readings of 4.2% for April 2021 and 5% for May have been somewhat dramatic, approaching highs last seen in 2008 and 1990. But it’s also important to remember that CPI is a year-over-year measurement – and 2020 was not a typical year. Current consensus is that these higher readings will most likely moderate as the economy continues to reopen.
Figure 2 – Just a Number? 40 Years of CPI Data
Source: Bloomberg (1/31/1981–5/31/2021)
Interestingly, the Federal Reserve also incorporates an inflation target into its monetary policy goals. The Fed has a dual mandate: to foster economic conditions that result in price stability as well as in maximum sustainable employment. But the Fed uses a different inflation measure, the PCE (Personal Consumption Expenditures price index), which tends to be lower than CPI due to the composition of its index. The May 2021 PCE reading was 3.9% – again somewhat elevated from the year before, but still well within its historical range.
Inflation and Investing
Because any level of inflation erodes the value of today’s dollar, earning returns that outpace inflation is a primary goal for most investors. That’s why investment professionals recommend some level of stock market exposure, even for the most conservative investors. Modest inflation generally benefits stocks, because it neutralizes the risk of deflation which can dampen performance. Inflation also tends to rise in a strengthening economy, as we are seeing this year, and that can help stock prices. Stock market indexes have continued to hit new highs in 2021.
Real estate is also a natural inflation hedge, as inflation tends to push property values up. Investors can access that market using a real estate mutual fund that invests in REITs (Real Estate Investment Trusts). A REIT is a company that owns or operates income-producing properties such as office buildings, shopping malls, apartments, hotels or self-storage facilities. REITs trade like stocks and pay dividends to investors.
Finally, for a more direct link to changing inflation rates, fixed income investors may want to consider Treasury Inflation-Protected Securities (TIPS). TIPS are bonds issued by the US government that are specifically designed to protect investors from a loss of purchasing power by increasing their principal value in line with changes in inflation, as measured by the CPI.
While inflation will come and go, a well-diversified portfolio remains one of the best ways to protect purchasing power over time.
Inflation-protected securities move with the rate of inflation and carry the risk that in deflationary conditions (when inflation is negative) the value of the bond may decrease.
Real estate investing may be subject to risks including but not limited to declines in the value of real estate, risks related to general economic conditions, changes in the value of the underlying property owned by the trust, and defaults by borrowers.
Interest rate risk is a major risk to all bondholders. As rates rise, existing bonds that offer a lower rate of return decline in value because newly issued bonds that pay higher rates are more attractive to investors.
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