While it’s still not clear whether higher inflation is here to stay, it certainly made a comeback in 2021. The combination of near-zero interest rates, aggressive governmental stimulus, pent-up demand and supply chain woes are considered by many to be key ingredients in the rising inflation scenario. So how concerned should investors 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 (Figures 1 and 2).
Figure 1 – Spending Categories Included in the CPI
Source: Bureau of Labor Statistics
Figure 2 – Inflation Levels Are Well Above Their Historical Average, but Still Well Below Their Historic Peak
Source: Bloomberg (1/31/81–12/31/21)
It’s important to remember that the Fed has a dual mandate: to foster economic conditions that result in price stability (by adjusting interest rates) as well as in maximum sustainable employment. When inflation heats up, the Federal Reserve raises the federal funds rate, which is the rate that banks use to lend to one another. But the Fed uses a different inflation measure, the PCE (Personal Consumption Expenditures price index). PCE tends to be lower than CPI due to the composition of its index, and it is released later each month. The November 2021 PCE reading was 5.7% – also a notable increase from the year before, and Fed Chair Jay Powell has indicated that rates will rise in 2022.
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 saw in 2021, and that can help stock prices. Stock market indexes continued to hit new highs in 2021 and the S&P 500® Index gained 26.9% for the year.
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, and that index returned 35.7% in 2021.1
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. The calendar year 2021 return for TIPS was 5.96%.2
While the inflation outlook for 2022 and beyond is still uncertain, a well-diversified portfolio remains one of the best ways to protect purchasing power over time.
2 Source: Bloomberg
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed may change based on market and other conditions. All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There can be no assurance that developments will transpire as forecasted, and actual results may vary. Investors should fully understand the risks associated with any investment prior to investing.
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.
The FTSE Nareit Composite REIT Index is a free-float adjusted, market capitalization-weighted index of US Equity and Mortgage REITs. Constituents of the Index include all tax-qualified REITs that also meet FTSE's minimum size and liquidity criteria.
S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
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