Inflation: What investors need to know

May 7, 2018 | By Philip Taylor

Philip Taylor
Senior Managing Director, Invesco

After years of relatively low volatility, stocks took a steep dive in the early days of February, following the news that wages in January had jumped much higher than expected. Wage growth is certainly good for employee paychecks — they’ll have more money to spend, which would seem to bode well for the economy. So why did stocks react so negatively? One important reason is that sudden, steep wage increases could be a sign of inflation — and inflation could prompt the US Federal Reserve to raise interest rates faster than expected, cutting off the supply of “easy money” and low borrowing costs that corporations have enjoyed for so long.

Signs of inflation eased after that initial shock, but wage growth picked up again in March.1 Given all of the focus on this issue so far this year, investors may have questions about the causes and implications of inflation. To help explain, I’ve asked Invesco’s Chief Global Market Strategist, Kristina Hooper, a few key questions that are on the minds of many investors at the moment.

Q: What is inflation, and what’s the difference between various indicators like “headline inflation” and “core inflation”?

Simply put, inflation is an increase in the level of prices of goods and services. Economists measure inflation by creating a “market basket” of various goods and services and following those prices over time. There are a variety of different measures of inflation, but perhaps the best known is the CPI – the consumer price index – which is published every month by the Bureau of Labor Statistics. “Headline inflation” refers to the CPI. “Core inflation” refers to the CPI minus food and energy prices. Economists prefer to follow core inflation because food and energy are often volatile due to non-economic forces such as the weather or geopolitical tensions.

Q: What causes inflation, and why is high inflation negative for the economy?

Inflation can be caused by either internal or external forces. For example, “demand-pull” inflation occurs when the demand for goods and services in an economy rises faster than supply. This can happen when there’s an increase in the supply of money — which can then cause central banks to tighten their monetary policy and raise interest rates.

“Cost-push” inflation occurs when producers raise their prices because their costs have increased. This can occur when, for example, unemployment decreases and employers need to pay more for workers — which is what we saw in January. They typically push that cost to consumers in the form of higher prices.

No matter the cause, high inflation reduces people’s purchasing power, which can hinder economic growth.

Q: What about its opposite — deflation?

Deflation is a fall in prices, and that is negative for the economy as well. If consumers expect prices to fall, it encourages them to postpone their spending because they believe they can get a better deal on their purchase if they wait. That stifles economic growth.

Q: If extreme inflation and extreme deflation are negative for the economy, is there a “happy medium” that the Federal Reserve wants to see?

Yes — the Fed’s stated inflation target is 2% per year. The rationale is that a moderate level of inflation encourages people to spend now because they anticipate costs will go up in the future, but it doesn’t dramatically erode purchasing power.

Q: Investors may worry about their portfolio returns keeping up with inflation, so that they don’t lose purchasing power over time. What are some ways to potentially hedge against the negative effects of inflation on a portfolio?

There are a variety of asset classes that may provide some level of inflation hedge. One option is commodities — if the prices of goods and services are rising, then the price of commodities may also be rising at a similar level. Another is real estate, for that same reason. Also, dividend-paying stocks may offer a hedge against inflation if companies increase their dividend payouts at a pace that meets or exceeds the pace of rising prices. Finally, about two decades ago, several countries created instruments specifically designed to hedge against inflation: They’re called inflation-protected securities – also known as inflation-linked bonds. Some of the best known are TIPS (Treasury Inflation Protected Securities, issued by the US government) and LINKERS (issued by the UK government). In general, the outstanding principal of these bonds is tied to inflation — this means the principal goes up when inflation goes up, and therefore the interest paid on that principal rises as well.

Q: What’s a good source if I want to see the current inflation rate or look at its trend over time?

As noted previously, the CPI is perhaps the best-known inflation indicator. The Bureau of Labor Statistics has a web page dedicated to the CPI, including its latest reading and changes over the last 12 months.

The Fed tracks several inflation measures, with particular emphasis on the personal consumption expenditure (PCE) data that’s reported by the Department of Commerce’s Bureau of Economic Analysis. The Fed offers this simple explanation of how it evaluates inflation.

With any inflation indicator, the Fed pays more attention to core rather than headline inflation, since the headline data can fluctuate a lot more.

1 Source: US Bureau of Labor Statistics

Important information

     The opinions referenced above are those of Kristina Hooper as of March 31, 2018. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.
      The value of inflation-linked securities will fluctuate in response to changes in real interest rates, generally decreasing when real interest rates rise and increasing when real interest rates fall. Interest payments on such securities generally vary up or down along with the rate of inflation. Real interest rates represent nominal (or stated) interest rates reduced by the expected impact of inflation.
     Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.There can be no guarantee or assurance that companies will declare dividends in the future or that if declared, they will remain at current levels or increase over time.
     Investments in real estate related instruments may be affected by economic, legal, or environmental factors that affect property values, rents or occupancies of real estate. Real estate companies, including REITs or similar structures, tend to be small and mid-cap companies and their shares may be more volatile and less liquid.
     Commodities may subject an investor to greater volatility than traditional securities such as stocks and bonds and can fluctuate significantly based on weather, political, tax, and other regulatory and market developments.
     The consumer price index (CPI) measures change in consumer prices as determined by the US Bureau of Labor Statistics.