It is a truism of capital markets that, whereas the most apparent risk is least dangerous, the least apparent risk is most dangerous. Obvious risks can be factored into an economic forecast, or reflected in security analysis and valuation, and inform asset allocation and portfolio construction. Surprises, on the other hand, are disruptive. Our topic this quarter is one of these least apparent risks: inflation.
Nobody is interested, nobody cares, and nobody seems to be worried about the threat of rising prices. The relative frequency of search terms on Google illustrates the lack of concern or even interest in the matter, at least in the United States. Searches for the term “inflation” peaked in April 2008, and interest in “cost of living” and “consumer price index” peaked in 2004. We apparently have plenty of other things to worry about.
There is a valid reason for this apathy – for all intents and purposes, there is very little inflation at present. Headline inflation, as measured by the Consumer Price Index (CPI), has risen at or below 2.0% for the past five years, and has even dipped into negative territory (deflation) twice in the past decade. If we remove the volatility of food and energy prices to arrive at a measure of core inflation, prices have been even steadier. Core CPI has averaged a modest 1.9% over the past 15 years, and both measures have decelerated over the first few months of 2017.
Where Does Inflation Come From?
As many of us learned during our freshman year of college in Economics 101, the price of anything and everything is determined by supply and demand. We are accustomed to thinking of inflation as a supply-driven phenomenon, largely because notable accelerations in inflation have historically resulted from a constrained availability of goods. A particularly cold winter in Florida can damage citrus crops and drive up the price of orange juice at the grocery store. A coffee rust outbreak in Central America a few years ago doubled the price of imported coffee beans. The Arab oil embargo of 1973 prompted a quadrupling in the price of crude oil and led to lines for gasoline that stretched for blocks.
These examples demonstrate a common thread of supply-driven inflation. It usually results from some natural or political development, such as weather or retaliatory trade action, and rarely spreads to the economy as a whole. There is, for example, no reason for higher coffee prices to affect any other goods. Supply-driven inflation tends to be cyclical: Once the weather improves or political objectives change, prices revert to more normal levels. The oil shock of 1973 was an exception to this rule, as energy prices have broad effects throughout the economy – although those effects are much smaller now than a generation ago as the U.S. economy has shifted toward a greater reliance on services and technology, as opposed to manufacturing.
Of greater concern are secular increases in inflation that have far-reaching economic effects, and these tend to be driven by wages. The linkage is rather straightforward: A general increase in wages and personal income boosts consumers’ ability and willingness to spend more money on a wide range of goods and services. The threat of this source of inflation is that it can become endemic. Wage growth leads to higher prices, which leads to increased wage demands, which leads to higher production costs, which leads to higher prices, et cetera. Once underway, this “wage-price spiral” can be difficult to break.
Once again, there seems to be little cause for alarm on this front, as wages have accelerated only modestly over the past several years. In this eighth year of an economic cycle, with the unemployment rate at a 10-year low of 4.4%, wages are growing at an annual pace of less than 2.5%, barely ahead of inflation. Economists debate without firm conclusion why this is the case, but the answer probably lies in some combination of greater use of technology and, paradoxically, the fall in worker productivity. Wages typically rise in line with inflation plus productivity, so in an environment of low inflation and productivity gains, we should not expect to see upward wage pressure, regardless of the unemployment rate. Employers furthermore note that non-wage costs, such as employer-provided healthcare insurance, are increasing at a far faster rate than wages. The cost of employment is rising, but it is not fully reflected in the wage component. The interaction and direction of causality between wages, productivity, technology and inflation is a topic for another day.
What Role Does the Federal Reserve Play?
In the wake of the inflation of the early 1970s, Congress explicitly handed responsibility for managing inflation to the Federal Reserve, the central bank of the United States. The Federal Reserve Reform Act of 1977 requires the Fed to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
In its pursuit of price stability, the Federal Reserve is more concerned with restraining demand-driven, or wage-driven, inflation, for the simple reason that monetary policy has little influence on supply issues. Fed policy cannot address the weather in Florida or the health of Brazilian coffee crops. The Fed’s so-called dual mandate requires it to balance the strength of the labor market with the risk that too much employment growth might lead to wage-driven inflation.
Historically, this has required the Fed to walk a fine line in keeping interest rates low enough to support economic activity and hiring, but not so low that a booming economy leads to excessive wage gains and inflation. This has been an easy exercise over the past decade, at least in retrospect, as the Fed has been more concerned with the risk of deflation than inflation. As a result, the Fed has been able to keep interest rates low for an extended period without allowing inflation to creep into the economy.
In fact, as interest rates in the United States approached zero in the 2008/2009 financial crisis, the Fed added to its policy arsenal by expanding the size of its balance sheet through so-called quantitative easing. This involves the Federal Reserve buying fixed income assets from financial institutions in the open market and paying for those purchases by crediting the seller with newly created reserves held at the Fed. Buying assets allows the Fed to exert further downward pressure on interest rates (bond yields go down as prices go up) while boosting bank reserves in an effort to incentivize lending. More lending translates into more business expansion, home purchases, renovation, consumption, et cetera – and consumption, broadly defined, drives almost 70% of gross domestic product (GDP). Through various rounds of quantitative easing, the Federal Reserve grew the size of its assets from about $900 billion in summer 2008 to the current level of roughly $4.5 trillion.
In expanding the size of its balance sheet so dramatically, the Fed runs the risk of falling short on its commitment to keeping prices stable. The laws of supply and demand apply to money as much as to goods and services, and expanding the amount of money in circulation or available for lending raises the risk of inflation. We normally think of inflation as a rise in the price of goods, but this is equivalent to a fall in the value, or the purchasing power, of the dollar. Rising prices and falling purchasing power are two sides of the same coin.
The economist Irving Fisher referred to this as the “money illusion” in a 1928 book with that title. The illusion is that the dollar is stable while prices fluctuate, which Fisher compared to the pre-Copernican notion that Earth remained still while the rest of the heavens revolved around it. The astronomical and monetary reality is that everything is moving and that the supply of and demand for dollars can affect the market price of goods as much as the supply of and demand for the goods themselves.
Money Supply and Velocity
And yet, as the earlier graph demonstrates, even with zero interest rates and a fivefold increase in the size of the Fed’s balance sheet, prices and wages remained stagnant. Why? Because money is inflationary only if it moves. If I pay someone $100 and she does nothing with the income, there is no impact on demand or prices. This is the monetary concept of velocity, which measures how many times money transfers from one economic actor to another, influencing prices with every move. In this example, my $100 payment represents a velocity of 1, as the money only changes hands once. If, on the other hand, the recipient of my $100 subsequently spends $50 on dinner and a movie and $50 on a taxi to get home, the velocity rises to 2 ($200 in aggregate money flows divided by a total of just $100 in circulation). My spending is someone else’s income, and the more times that happens, the greater the velocity and the more pressure on prices. Expand this simple example to about $13 trillion, and you get the U.S. money supply. At the aggregate economic level, money velocity is GDP divided by the total supply of money (including cash and bank deposits).
As the nearby graph shows, in spite of modestly rising wages and the growth in the Fed’s balance sheet, money in the U.S. economy is moving increasingly slowly. The absolute level of money in circulation is at an all-time high, but the movement of that money is at an all-time low. From a peak of 2.2 in the third quarter of 1997, the velocity of money has slowed to a low of 1.4 as of the first quarter of this year.
What Are the Risks of Inflation Today?
If the story ended here, we could claim a permanent victory against inflation and turn our attention back to other and more apparent risks facing the economic and financial markets. Wage growth is sluggish, the velocity of money supply is declining, and economic growth is modest at best. Yet ignoring the risk of inflation, as remote as it may be, could lead to unpleasant surprises.
We observed earlier that we have not seen much inflation in this economic cycle, but perhaps we should insert the word “yet” into that claim. Economic growth has been so slow, and this cycle has been so protracted, that perhaps the inflationary pressure we typically see earlier in an economic expansion just hasn’t occurred yet. As the unemployment rate creeps lower (down to 4.4% as of June), the labor market tightens, and at some point, the laws of supply and demand do come into play. Furthermore, the unemployment rate for people with a bachelor’s degree or higher has fallen to a mere 2.4%, implying that 97.6% of the people in the United States who have a college degree and want a job have one. The number of job openings is rising, and eventually, employers will need to raise their offers to lure workers into these jobs. This dynamic usually unfolds earlier in an economic cycle, but the record low pace of growth in this cycle may have simply delayed that occurrence.
Inflation could also accelerate due to increased corporate spending or a surge in bank lending. Corporate balance sheets are healthy, providing plenty of ability to invest, and bank balance sheets are similarly robust, which creates ample lending power. Either development would lead to a rise in the velocity of money, even without pressure from wage growth.
In spite of the absence of inflationary pressure at present, the Federal Reserve is paying more and more attention to the risk, pointing to it as a primary reason for moving toward a more normal monetary policy. So far, the Fed has tightened monetary policy by raising interest rates, and will likely complement this policy shift by starting to reduce the size of its balance sheet in an orderly way this autumn. The language around Fed discussions demonstrates that inflation is increasingly a topic of conversation at Federal Open Market Committee (FOMC) meetings, as the nearby word cloud illustrates. This visual analysis correlates the size of each word with the frequency of its appearance in the statement released by the Fed at the end of its June meeting. Inflation is literally front and center.
These cyclical inflationary risks are, however, balanced by deflationary secular trends. Although seemingly out of favor both in Europe and the United States, globalization brings down prices. When companies can lower their costs by relocating production facilities to cheaper areas, the benefits accrue to corporate profits and to consumers through lower prices. The impact of globalization on jobs is more politically sensitive, but with a low unemployment rate, it is not clear that globalized markets have done lasting damage to the U.S. labor market.
Globalization depends on technology, and technology is generally deflationary. Increased productivity reduces per-unit costs of production, enabling companies to lower prices. Here, too, the economic debate rages as to exactly how technological advances boost productivity, and whether that trend is as powerful now as it was in the past. Another topic for a different day.
Globalization and technological innovation are not going away and should continue to exert deflationary pressure throughout the developed world. Where the cyclical risk of wage-driven inflation is a real and present (if least anticipated) danger, these secular trends should prevent it from rising too rapidly.
Why the Worry?
So why, then, should we worry about inflation? Even if wage growth pushes prices up a little bit, inflation is low to begin with, and the secular trends discussed in the last few paragraphs will likely keep a lid on it. Yet investors should take inflation into account for two primary reasons.
First, a little inflation goes a long way. We are all familiar with the power of compound interest – how a small amount of money can compound into a great fortune over time, even at paltry rates of return. The so-called “rule of 72” captures this dynamic: 72 divided by the annual rate of return tells you how many years it will take to double your money. Inflation is simply the evil twin of compound interest. Inflation can cause a great fortune to dwindle into little purchasing power over time, and the rule of 72 can quantify this as well, substituting an inflation rate for a rate of return.
Consider the following graph, which illustrates the purchasing power of a dollar in various inflation scenarios. Even at a modest inflation rate of 2% (roughly the current level), the real value of a dollar drops by 40% over a 25-year period. This is by no means an unreasonably long time period for investors who want to protect and grow their wealth for their own benefit, as well as for the benefit of future generations. To make matters worse, an inflation rate of 2% does not generate alarming headlines, shifts in Fed policy, blue-ribbon commissions and calls to action. It is precisely the modest (but durable) nature of inflation that makes the risk so insidious. Higher rates of inflation pose a more obvious risk, but the real lesson of this graph is that the steady drain of even modest inflation greatly impairs purchasing power over time.
A second reason to pay attention to inflation is that not all inflation is created equally. The CPI is based on a basket of goods and services that is meant to represent the purchasing patterns of an average American consumer. The basket is updated from time to time to account for product developments and shifting consumption trends, but no single snapshot of spending habits can adequately capture the range of American consumption. Most of our readers probably spend money in a very different way from the CPI basket of goods.
Housing, transportation and food account for three-quarters of household spending for the average American. Housing (which includes rent, maintenance and utilities) may not be as big of a spending area for families with substantial wealth. The inflation calculation adjusts for home ownership by calculating a “rent equivalent” for an owned home and then tracking the change in comparable rents. This makes statistical sense, but homes tend to be more of an asset than a big spending category (although they can obviously be both) for families with wealth. Transportation (which includes vehicles, gasoline and maintenance, as well as public transportation) similarly might not take up 15% of your own budget. On the other hand, recreation and (depending on how many kids or grandkids there are) education are far more important spending areas for many of our clients.
To the degree that your own spending patterns differ from the CPI basket, so, too, will your own rate of inflation. As an example, consider the change in the CPI level for two broad categories over the past 25 years. The following graph shows the index levels for healthcare and apparel prices, along with the overall CPI, all based to 100. Apparel prices are actually down over the past quarter century, due mostly to globalization, whereas the steady rise in healthcare costs is a well-known and heavily debated trend. Perhaps you should not take too much comfort in the apparently low rate of CPI inflation. Your own inflation rate might be quite different.
How Can I Protect Against Inflation?
Inflation poses a risk to your balance sheet: It drives up the cost of your liabilities (spending, lifestyle, philanthropy, tuition, healthcare and so forth) while threatening the purchasing power of your money. The best way to protect yourself against the threat of inflation is to make sure that the purchasing power of your assets (investments) keeps up with the rising prices of your liabilities. The solution to this challenge lies primarily in asset allocation.
Some asset classes provide better protection against inflation than others, although as the following graph demonstrates, a wide variety of investments have outpaced inflation over the past 25 years. Stocks led the way over this timeframe, with a compound return of 9.0% for the large-capitalization S&P 500 (including dividends). Companies usually have the ability to protect their own revenues and profits against inflation to some degree by raising the prices of the products and services they provide. This is not so good if you are a customer, but it offers some inflation protection to owners and shareholders through higher earnings. Of course, not every company enjoys pricing power, which is why disciplined and active stock selection plays an important role in protecting portfolios against inflation as well.
Real estate comes in a close second to equities in this historical snapshot for a similar reason. Landlords usually have the ability to raise rents on their properties, mitigating the effect of inflation. This is simply another form of pricing power, and, as with companies, some real estate properties have more control over rents than others. Hotels, for example, can reprice rooms in response to inflationary pressure more rapidly than commercial buildings can renegotiate longer-term leases. Once again, active management is important.
Surprisingly, municipal and corporate bonds have also beaten inflation over the past 25 years, but this observation requires two caveats. First, at only 2.3%, inflation has not posed a terribly high hurdle over this period. Second, the last quarter century was marked by a secular drop in interest rates (and therefore rising bond prices) that will be difficult to repeat. The 30-year Treasury bond offered an average yield of 7.7% in 1991 vs. a yield of 2.9% today. Bond yields might fall from current levels, but it would be unwise to make that bet for the next 25 years.
By virtue of the fact that the vast majority of bonds are structured in nominal terms, inflation is explicitly ignored. A creditworthy bond repays principal in nominal dollars, even if those dollars do not have the purchasing power they did when the bond was issued. The bondholder bears the risk of inflation eating away at the real value of her interest income and principal repayment. Bonds are traditionally a source of income and haven of price stability but offer poor protection against inflation.
Gold posted the weakest return over this period, although it still beat inflation. Gold’s appeal lies in its historical utility. For millennia, humankind has relied on gold as a store of value, although that reliance is clearly not based on the metal’s ability to generate economic value. Indeed, for most of history, currencies throughout the world were directly tied to a defined unit of a precious metal. The inability to derive an intrinsic value for an ounce of gold leads us to prefer other sources of inflation protection for portfolios, primarily carefully selected equities both in the United States and abroad.
As the lawyers always remind us, past results are no guarantee of future success, and this is true for asset classes as well. Beginning and ending points matter. The 25-year period in the previous graph starts in a relatively poor period for stocks and bonds and concludes in 2016 in a well-seasoned bull market – hence the need for disciplined portfolio reviews, regular rebalancing and a keen understanding of valuations.
Inflation is dormant, but it is not dead. In a political environment dominated by debates about healthcare, tax reform, security, budgets and debt ceilings, inflation is not today’s problem. Furthermore, secular trends in global trade and worker productivity imply that inflation will not be tomorrow’s problem either, although rising federal debt (in all its forms) could readily introduce inflationary pressure in the future.
Inflation should nevertheless be a concern of any family seeking to protect, preserve and grow its wealth for the benefit of future generations. It is precisely the fact that inflation poses a least apparent risk that makes it most dangerous. And, as we have seen, it does not take much inflation to eat away at the value of a dollar. The solution to the challenge takes the form of careful asset allocation, portfolio construction and security selection.
After all, at the end of the day it is not how much money you have that counts. It’s what you can do with it.
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