Is inflation coming? This is a question that is on a lot of people’s minds these days, and can be difficult to answer.
In general, inflation happens where there’s too much money chasing too few goods and services. When central banks increase the money supply (such as the economic stimulus response to COVID-19), then there is that potential for unhealthy inflation to occur.
We’re going to take a look at indicators of inflation, historical inflation, and what investments you can buy to protect yourself against inflation.
As a quick review, inflation is a measure of the average price increase for a basket of goods that include key items that everyone needs. This includes items such as:
- And many more everyday goods/services….
Indicators of Inflation
When people start seeing prices increase dramatically, then there is always a worry that a great inflationary period is coming. Rising prices for common items are a great indicator of rising inflation. These price increases and decreases are usually captured in the Consumer Price Index (CPI).
For example, in 2021 the prices for things such as lumber, copper, and even Kleenex tissues are rocketing up by over 20%. The crazy thing is that people are also accepting these price increases without much hesitation.
Here’s another indicator of inflation: the Purchasing Manager Index (PMI). These business surveys are done around the world, and indicate that the prices paid by businesses for their raw materials are at the highest levels they have been since 2008. Rising costs for businesses usually results in rising prices for consumers.
When these inflationary indicators increase, then there is no doubt that inflation is occurring. However, a little bit of inflation is not bad – we just need to stay away from sustained high inflation.
To better understand how unhealthy inflation can play out over a long period of time, let’s take a look at the United States from the 1960’s to the 1980’s.
If we look at the data, then we’ll find that the 1970’s was the only time we have ever seen unhealthy sustained peacetime inflation with data going back to the 1200’s. Inflation usually increased a lot during major wars (eg. Napoleonic, WWI, and WWII), but was otherwise not sustained during peacetime.
So what happened in the 1970’s? First, the United States drastically increased its spending in the late 1960’s as part of social programs as well as the Vietnam war. The money supply increased, and capacity constraints started to be seen in the economy due to too much money chasing too few goods and services.
This all sounds pretty familiar even in the 21st century, but we haven’t seen the type of inflation that was present in the 1970’s. Why?
One of the main reasons is because central banks are now willing to raise interest rates – much more so when compared to the 1970’s. Central banks were not as willing to raise the benchmark rates because they weren’t sure that it would necessarily help curb inflation.
The thinking in the 1970’s was that if the interest rates went up, then wages would have to immediately follow to offset debt servicing costs so the net result wouldn’t halt inflation. There was also the concern that raising rates would severely reduce employment. As we have learned since then, raising rates actually does work to help curb inflation in an acceptable manner.
Another difference between now and the 1970’s is the increase of globalized trade. If the cost of labor starts going up too much locally, then companies will start to offshore production to cheaper locations in order to keep costs and prices down.
Finally, the contribution of technology cannot be overstated when we compare the 21st century to the 1970’s. Imagine if the COVID-19 pandemic had occurred before the internet. Most people would not be able to work from home, and productivity would’ve greatly suffered – again resulting in too much money chasing too few goods and services.
Investments to Protect Against Inflation
If we think that a great inflation is coming, then what assets should we be putting money into? Here are some assets that tend to do well in an inflationary environment.
Series I Savings Bonds. The returns for these bonds are directly linked to inflation. As inflation starts to occur and indicators such as the CPI increases, the bond returns are adjusted to account for that increased inflation.
Treasury Inflation-Protected Securities (TIPS). These bonds are also linked to inflation, but the returns are typically worse than the Series I Savings Bonds. Series I Bonds are only available to individuals so institutions are basically stuck with buying TIPS bonds. However, there is a yearly limit on how much Series I Bonds someone can buy, so TIPS bonds are a good option if they’ve maxed out the Series I Bond amount.
Real Estate Investment Trusts (REIT). A REIT is a company that owns income-generating real estate properties, and the REIT trades just like a stock on the markets. Real estate and rent values usually increase with inflation, so these companies are able to turn higher inflation into higher revenues and profits for their shareholders.
Gold and other commodities. When inflation goes up, the prices of gold and other commodities usually go up as well. However, there is always a moderate risk that a commodity’s value may crash independent of what is happening with inflation. For example, if inflation goes up but oil production goes up even more, then oil prices may actually go down.
Is a Great Inflation Coming?
The moral of the story here is no one will really know until it’s too late. There will for sure be inflation, but will there be a sustained period of a great inflation? It can certainly happen, but is not guaranteed.
There are so many variables and levers that central banks and businesses can play with. Betting the farm on inflation happening or not happening is likely not a wise move.
Your portfolio needs to have some assets to protect against inflation in case unhealthy or hyperinflation occurs.
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