6 Charts Explaining Inflation: Why it Matters to You and What You Can Do About It
A revolutionary innovation from 1780 can protect your portfolio from inflation
In the late 1770s, the Revolutionary War wasn’t going well for America. The British Army had captured Georgia and Charleston South Carolina, and the British Navy was blocking the U.S. eastern coast. U.S. Army morale was low as the troops were poorly clothed, poorly fed, and often in need of medical attention. Mutinies were a real threat. Also sapping morale was another enemy: soldiers were facing a loss of value of their pay due to inflation.
But in 1780, The Commonwealth of Massachusetts rode to the rescue, with a financial innovation that perhaps played a small role in the eventual turnaround in army morale, and consequently America’s fortunes. That famous midnight horseback rider, Paul Revere, played a bit role, but not at all in a way you might have expected. Forgotten for centuries, the financial innovation was reinvented in the 20th century, and is a tool for you to consider if you are concerned about inflation — more about that truly “revolutionary” instrument below.
Fast-forward to today and the enemy is back. You’ve probably seen the headlines: U.S. consumer prices recently increased by 4.2 percent over the past year, the fastest rise since 2008. Are you ready for inflation? I’ll explain in six charts how inflation is measured, where it’s been, where it might be going, why it matters, what to watch, and what you can do about it.
How Inflation is Measured
Inflation is measured by monthly price changes in the typical basket of goods and services that the average person consumes. Here’s what that basket looks like:
The major categories of consumer spending are housing, transportation, food, medical care, recreation, apparel, education (which includes commun-ication), and other goods and services. While there are a variety of inflation measures, changes in the prices of this basket are known as the consumer price index or CPI changes. Of course, your basket probably looks different. By keeping track of your expenditures, you can get a sense of what your own spending basket looks like, and consequently what your personal inflation rate is.
Headline versus Core Inflation
Headline inflation refers to the price change of all items in the basket. In April 2021, prices were up 4.2 percent compared with April 2020 prices, which coincided with the onset of the Covid-19 pandemic. Many small businesses were shutting down. We spent much more time at home. With lower demand for gas, energy prices dropped. From that exceptionally low base, energy prices have dramatically rebounded, up about 25.1 percent.
Core inflation adjusts for two particularly volatile categories, energy and food. In the last year, food costs increased at the more modest rate of 2.4 percent. Removing these two categories, the core inflation rate is at 3.0 percent — much lower than the headline rate, but still relatively high. Keep an eye out for this core rate.
A Century of Inflation
Here’s a longer look at U.S. inflation since 1914.
We see a number of different inflationary regimes. During and just after both World Wars (1914–18, 1939–45), prices increased at rates approaching 20 percent or higher, and again but not as dramatically around the start of the Korean War (1950–53), and in the 1960s around America’s involvement in the Vietnam War. Energy price increases also played a big part in inflation rises in the 1970s. The highest inflation since the Second World War occurred in 1980, when the rate was just below 15 percent. It took major action by Federal Reserve chair Paul Volcker, who substantially increased interest rates, to wrestle inflation at the cost of a major recession.
We’ve also seen some periods of deflation, when prices actually dropped (not to be confused with disinflation, which refers to rising prices, but at a lower rate of increase than previously experienced). The most severe cases of deflation occurred around 1921, then again during the Great Depression, particularly between 1930 and 1933. In both of those instances, prices dropped at an annual rate of -10 percent. More recently during the Financial Crisis, prices dropped marginally between March and October of 2009. Sustained deflation is bad because if it becomes ingrained and prices are expected to drop, consumers will postpone purchases and reduced demand can cause economic activity to stagnate, as Japan experienced since the early 1990s after bursting asset bubbles in stocks and real estate. In such a liquidity trap, there is little room for central banks to stimulate through reducing interest rates.
The Federal Reserve’s mandate is to foster economic conditions that achieve stable prices, or inflation of around 2 percent annually (along with moderate long-term interest rates and maximum employment). In the last three decades we have witnessed ideal price stability: since 1992, inflation has averaged 2.2 percent annually. That’s why recent price increases have sounded alarm bells.
Temporary Versus Permanent Inflation
Why is price stability so important? Imagine you own a business that includes a vast labor force, manufacturing and selling widgets. Business is good and you’re looking to expand your facilities. You need millions of dollars in capital — equity and loans — in order to invest in the expansion. If you do invest, you will be satisfying growing demand and also providing more jobs. It’s easy to make that decision with low and steady inflation. You aren’t expecting much of an increase in per employee labor costs. Contrast that with a high inflation environment — there is much more uncertainty. Facing increasing inflation, will employees demand higher wages? What will be the impact on increasing costs associated with the investment? Will customers tolerate higher widget prices? So, low and steady inflation is beneficial because it removes uncertainty.
Now let’s take a closer look to see what’s been happening over the last couple of years, since just prior to the start of the pandemic. The following chart paints that picture:
Pre-pandemic, inflation was close to the Fed’s target, at 2.3 percent in February 2020. By May inflation was close to zero. Since we are measuring inflation on a year-over-year basis, that’s significant because the recently-released April 2021 price numbers are being compared with late-April 2020 prices. So, it’s no surprise that the jump in inflation looks considerable. We can expect to see these temporarily high numbers for the next several months. There are other factors at play as well. In some sectors such as computer chips, supplies are low which can lead to higher prices. Low interest rates, stimulus checks, and abnormally high savings rates related to people staying at home and spending less have also played an important role.
So, while there are reasons not to fret over temporarily high inflation, there is some cause for concern as well. When does temporary inflation become permanent? In 1976, inflation was below 5 percent; by 1980 it was almost 15 percent. It can be a slippery upward slope that’s hard to break — be on the lookout.
Which leads to an important distinction between past inflation and expected inflation. If I’m negotiating my next salary, what matters most is expected inflation. What will hurt me the most is unanticipated inflation. For example, if I negotiate a contract that will pay me 2.5 percent more than I made last year based on my anticipated inflation of 2 percent, then I expect my real gain to be 0.5 percent. However, if actual inflation turns out to be 3 percent, then in real terms (that is, adjusted for inflation), I’ll be worse off.
We can measure expected inflation, known as the breakeven inflation rate, as in the following chart:
I’ll explain below where this breakeven inflation rate cones from. For now, let’s think of it as a (rational) investor’s expectation of inflation. Think of it as the response to a daily survey: “What do you expect the average annual inflation rate will be over the next 10-years?”
What we see from this chart (back to 2003), is that most of the time investors were expecting inflation to be in the 1.5 percent to 2.5 percent range — not far off from what the Federal Reserve set as a goal for price stability. Only occasionally has the rate exceeded 2.5 percent. For perspective, the actual average annual inflation rate since 1914 is 3.2 percent. During the Financial Crisis of 2008–2009 and again during the 2020 pandemic, with the threat of severe recessions, expected inflation collapsed to near zero. But in the past year, as in 2009, we’ve seen a steady climb. And it’s that trend that looks worrisome: are we simply returning to normal, or will expectations for inflation continue to rise? Pay close attention to inflation expectations.
Why Inflation Matters to You
We’ve already seen that inflation matters because it creates uncertainty, particularly for business looking to invest, and employees considering wage demands. Here are more reasons why inflation matters to you, and why you should pay attention.
- Inflation impacts on our standard of living. If our income and investments don’t increase at the rate of inflation, then it’s like we’re facing increased taxation. We may be forced to ration and make difficult spending decisions. At an annual inflation rate of 4 percent, prices will double in about 18 years (the rule of 72: take 72 divided by the rate, and that gives an approximation of years required to double).
- While over long horizons stock returns tend to provide real returns well in excess of inflation, in the short-term, stock prices tend to react negatively to increased inflation. The intuition is that stock prices reflected the discounted value of expected cash flows, and so when the discount rate increases because investors require higher nominal returns with higher inflation, then stock prices decline. That’s what we’ve seen recently.
- Inflation also hurts bond prices, in a more direct manner. Bond prices are inversely related to yields or interest rates. Higher inflation goes hand-in-hand with higher yields, bringing prices lower. Again, that’s been the recent experience.
- Inflation creates winners and losers, particularly if you are either a borrower or a lender — and by lender, that includes anyone who buys bonds. Imagine someone agrees to lend you $10,000 for 5 years at a rate of 5 percent, reflecting both the riskiness of lending money to you (let’s say a 3 percent risk premium) as well as expected inflation (let’s say 2 percent). If actual annual inflation over the next 5 years is 4 percent, then you are a winner and the lender is a loser, because the actual risk premium they will have earned is only 1 percent.
- If higher expected inflation becomes ingrained, there is a danger, albeit very small, of inflation spiralling out of control, known as hyperinflation. With 3 percent inflation as over the past century, prices double in about 24 years. One of the worst cases of hyperinflation occurred in Zimbabwe in 2008, when prices were doubling, on average, every 24.7 hours.
What to Do About Inflation
So, what can you do about inflation from an investment perspective? Look for investments that tend to preserve their value relative to inflation. Gold has historically been seen as a long-term hedge against inflation. Other commodities tend to do well relative to inflation. That may means relying on futures contracts rather than owning the actual commodities, which can add complications, but there are exchange-traded funds that make such investing simpler. Real estate has also been seen as an inflation hedge historically, with a caveat that we may be seeing a disruption in both retail and commercial real estate post-pandemic, as many businesses may move more online relying less on bricks-and-mortar, and work-from-home may become more commonplace. Since longer-term bond prices react much more negatively to higher inflation and higher yields, if you are planning to hold bonds then shortening the duration of those bonds — the average time to get back coupons and the face value — can mitigate some of those negative effects. I recently wrote about the risk and return of bitcoin — I think it’s too early to tell whether cryptocurrencies will become an inflation hedge.
There’s one more important way to protect against inflation: inflation-indexed bonds. It’s the revolutionary innovation I alluded to earlier. According to Nobel-Prize laureate Robert Shiller, the Commonwealth of Massachusetts created the earliest known inflation-indexed bond, in 1780, called “depreciation notes.” Wartime is often associated with bouts of inflation, and the American Revolutionary War was no exception. The notes were designed so that both the principal and interest preserved their purchasing power. Here’s a sample of what the bonds looked like:
If you look closely, you’ll see that the bond specified a price index tied to a specific basket of goods, including corn, beef, wool, and leather. In other words, soldiers wouldn’t lose their purchasing power, which is the intent of these inflation-indexed bonds. While a great financial innovation, once high inflation abated after the war, the bonds were eventually replaced.
Fortunately, the concept was resurrected in the 20th century. In 1945, Finland became the first country to introduce inflation-indexed bonds and the list of countries has grown, notably the U.K. in 1975, Canada in 1991, and the U.S. in 1998. The U.S. bonds are known as Treasury Inflation-Protected Securities, or TIPS. Both the interest and principal are adjusted as the CPI changes. The government has issued a variety of TIPS with different maturities. When 30-year TIPS were initially issued in 1998, they offered a guaranteed real return (in excess of inflation) of around 3.63 percent when held to maturity. To put this real return in perspective, since 1926, stocks have average real annual returns of around 9 percent, albeit with much more risk than government bonds. The chart below shows the historical yield on 30-year TIPS.
As you can see, real yields have declined considerably. Today, 30-year TIPS yields are around zero. What this means is that by investing in them and holding them to maturity, you can preserve your purchasing power, but no more.
What’s a risk-free alternative to 30-year TIPS? It’s 30-year U.S. government bonds, not indexed to inflation. They are currently yielding around 2.4 percent. So back to the earlier chart (which is for 10-year bonds), that’s where the breakeven inflation notion comes from — it’s the difference between equivalent real return and nominal return government bonds. If you think inflation is going to be higher than the breakeven point over the time to maturity for the bond, then go with TIPS. But if you think inflation will be lower than the breakeven rate, you are better off with the nominal bonds. The beauty of TIPS is that you lock-in to a return (albeit a low one today) without worrying about inflation.
Oh, and what was Paul Revere’s bit part in the innovative 1870 inflation-link bonds? When he wasn’t out on a midnight ride to warn the colonial militia of a pending British attack, he had a day job — as a silversmith and an engraver. As the official engraver for Massachusetts, he apparently engraved the surrounding border on the 1780 inflation-indexed bonds!
Stephen Foerster is a co-author, with Andrew Lo, of In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest, Princeton University Press (August 17, 2021).