In this episode, Abrin sits down one-on-one with Sam Chaplin to discuss inflation. Sam is Associate Portfolio Manager at Penobscot Financial Advisors and is currently working on becoming a Chartered Financial Analyst with one test down and two to go.
What is inflation?
As Sam states, there are two main definitions of inflation: the increase in the cost of a good or service over time, or the decrease in the value of the dollar. If you need some examples, just look at the cost of candy or a bottle of soda today compared to a hundred years ago.
What causes inflation?
Sam explains inflation comes from the supply and demand curve on a basic level. Supply costs can drive up prices if the materials, labor, or other costs going into the final product increase. On the demand side, prices can go up or down with consumer spending which can be reliant on consumer wages and their incentives to buy versus save. Getting more technical, government spending and trade balances with other countries can also play role depending on how many dollars are in circulation and the value of the dollar versus foreign currencies.
How do we monitor inflation?
We watch the Producer Price Index (PPI) on the supply side and the Consumer Price Index (CPI) on the demand side. With the Producer Price Index, we are watching raw materials while with the Consumer Price Index we are watching the cost of a basket of goods. Currently, the indices are fairly high compared to historical averages.
Deflation and Stagflation
A couple of other terms related to inflation are deflation and stagflation. Sam and Abrin explore the negative impacts of deflation, where you can buy more goods and services for the same amount of money by waiting. This incentivizes saving one’s money and not pumping it into the economy. Stagflation takes place when we have high unemployment in the economy and high inflation.
Historical Look at Inflation
Sam points out, rather comically, that the historical chart of the Consumer Price Index going back to the 1920s looks a bit like an EKG with high inflationary periods in the 20s and 70s and 80s. Since the 90s inflation has been much less volatile and there has been a lot of debate about why that has been the case in recent history.
One theory is technology has increased efficiency to a point where supply is able to catch up to demand much more quickly than in the past, driving down consumer competition. Another has to do with aging demographics, where the older people get (and we have a larger older population in the US currently), the more likely they are to save money rather than spend it. The third theory covered is that we have a greater wealth distribution today where higher earners aren’t spending most of their money on items that get included in inflation calculations. The last theory covered is Modern Monetary Theory where basically the US government can increase the money supply without causing inflation because the US dollar is the world reserve currency. This allows demand to stay high relative to other countries’ debts and currencies.
Going back to the 2008 financial crisis, at that time we had a large increase in the money supply and yet didn’t see very high inflation during the following decade. Leading some to think today that we may be able do the same thing (print off a bunch of money, increasing the money supply in response to keeping the economy afloat during shutdowns) and not see a high inflation rate. Although, no one can predict the future and we’ll have to see if inflation ticks up going forward or not. On the rolling year, some areas most people will notice prices have gone up have been food and fuel costs, while travel remains depressed. The Fed is targeting slightly higher inflation today than they have in the past.
Calculating Expected Inflation
Sam notes a way of calculating expected inflation through the Treasury market. For example, if we compare a Treasury Bond to a Treasury Inflation-Protected Security (TIPS), which pays you the actual inflation over the life of the bond plus the bond’s normal yield, and the TIPS is paying 1% plus inflation and the Treasury bond is yielding 3%, that means the market expects 2% inflation.
Inflation’s Effects on Bonds
A bond is a debt security that pays you interest over the length of the loan. For example, you may give company XYZ $1,000 at 5% interest for five years. Over that time frame, you will receive $50 a year and your $1,000 back at the end of five years. If inflation is high over that five-year period though, that $1,000 you receive back at the end of the loan will buy less goods and services at that point, negatively affecting your return.
Inflation’s Effects on Stocks
With stocks, one of the ways you can value a stock is to say I need to earn X% to make it worth the risk of investing in it. This is your required return. For example, if you need a 7% real return on investment to achieve your goals and there is 2% inflation, you’ll need the stock to return 9%. So as inflation goes up, your required return goes up.
Another way inflation affects a company’s stock relates to inflation’s effect on interest rates. Rising inflation increases bond yields and interest rates. This increases the costs of capital for companies and projects that were feasible in lower interest rate environments may be less feasible or profitable going forward.
Inflation needs to be a consideration within a financial plan to keep up with the cost of living over time. If inflation is higher than expected, it can negatively affect a financial plan since your buying power is reduced. If inflation is lower than expected, it can be a windfall within a financial plan.
Gold, commodities, real estate, and other real assets have historically been a hedge against inflation. Cryptocurrencies are another interesting area on the forefront as a potential hedge in the future.
DISCLAIMER: The foregoing content reflects the opinions of Penobscot Financial Advisors and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security.
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