What is Inflation?
Inflation is the appreciation in prices of goods and services over time. An easy way to think about inflation and its impacts are to consider the value of one dollar over an extended timeframe. For example, in 1960, $1 bought you four burgers, one milkshake, one soda, and one fry from McDonalds. In 2018, $1 buys you a small fry (and heartburn). In essence, inflation erodes the purchasing power of a currency over time.
History of Inflation
Over the past twenty years, the United States has experienced a period of fairly low and consistent inflation, however, this hasn’t always been the case. As recently as the mid-1970s and early 1980s , the U.S. has experienced bouts of high inflation exceeding 10%, driven primarily by energy price shocks. Over the past fifty years, inflation has averaged 4.1% per year according to the U.S. Bureau of Labor Statistics (Consumer Price Index.)
Exhibit A: Historical View of Consumer Price Index (year-over-year change in index)
While the U.S. has periodically endured periods of “high” inflation, we’re been fortunate to avoid periods of “hyper-inflation”. Hyper-inflation is a period of very high and accelerating inflation; think of citizens using wheel-barrows of cash to buy everyday items. Germany saw hyper-inflation after World War I; what one German Mark bought in 1918 took over one billion Marks in 1924. Other examples of hyper-inflation include Zimbabwe between 2007-2008 and in Venezuela this year (the International Monetary Fund predicting the inflation rate will soon reach 1,000,000% by the end of 2018).
Why Measure Inflation
Measuring inflation in beneficial in multiple ways. The first primary benefit of measuring inflation is to provide policymakers such as the Federal Reserve an accurate gauge of price-levels. Maintaining stable prices is one part of the Federal Reserve’s mandate handed down by Congress in 1977, with the other mandates of maximizing employment and moderating long term interest rates. The second primary benefit of measuring inflation is to provide an adjustment to income payments such as Social Security. These “cost-of-living adjustments” are important to maintain the purchasing power of the income payments over time.
While there are many ways to measure inflation, common measures include the following:
Consumer Price Index (CPI)
CPI is a measure published monthly by the U.S. Bureau of Labor Statistics (BLS) and looks at the price changes of a basket of goods and services purchased by consumers. The basket includes categories such as Food, Housing, Energy, and Medical Care.
Personal Consumption Expenditures (PCE)
PCE is a measure produced by the U.S. Bureau of Economic Analysis (BEA) which evaluates inflation in household expenditures. The PCE is used in adjusting for inflation in the calculation of Real Gross Domestic Product (GDP). PCE is different from CPI in what is included in the basket of goods and services and how those goods/services are weighted. Sometimes PCE will be referred to as GDP Deflator.
While less commonly known than CPI, PCE is actually used more frequently by the Federal Reserve Open Market Committee (FOMC) in making interest rate decisions. The FOMC’s current inflation target of 2% is based on PCE.
Producer Price Index (PPI)
PPI is similar to CPI but is focused on the prices of goods and services used as inputs in creating other goods and services which is effectively the inflation businesses experience in their supply chains and business expenses.
Over the past decade, all three inflation measures tend to be highly correlated, however, there are differences. PPI tends to be more volatile than CPI or PCE as businesses often absorb some input price shocks. This means they pass along price increases in the inputs to their goods and services but often not 100% of the price increases. Separately, since its inception, PCE tends to have a slightly lower rate of inflation change than CPI. (3.6% vs. 4.1% annually over the past 50 years; St. Louis Federal Reserve Bank) According to the Cleveland Federal Reserve Bank, this is primarily a result of the basket weight method. Many economists, including the FOMC, believe PCE to be a truer measure of the actual inflation experienced by households as it does a better job accounting for the substitution effect. The substitution effect is the replacement of a good which has experienced price increases with a good which has not, for example, eating more chicken in lieu of beef if the price of beef has increased and chicken has remained constant.
Exhibit B: Comparison of Year-over-year Changes in Inflation Measures
In the news, you may hear about different versions of the CPI, including Headline CPI and Core CPI. Due to the volatility of some of the components in the CPI basket (Food and Energy), many economists like to view the index with and without those components. Headline CPI includes the entire consumer basket of goods and services while Core CPI excludes Food and Energy. As you can see in Exhibit C below, Headline CPI exhibit more volatility than Core CPI due to the inclusion of Food and Energy.
Exhibit C: Year-over-year CPI Components
What Drives Inflation?
There is no single item which causes inflation, instead it is a multitude of different factors. Economists tend to group the factors into two main categories, demand-pull and cost-push.
Demand-pull factors include expansionary monetary policies, expansionary fiscal policies, and increases in the money supply which causes a devaluation of the currency. In short, demand-push factors can be summarized as too much money chasing too few goods/services.
Cost-push factors include increasing wages costs and rising prices for the raw inputs to production, such as commodities like oil. You can think of cost-push factors as pass-through inflation; if the inputs increase in price, the outputs increase in price.
Impact of Inflation on Investments
It is always important is to consider the impact of inflation on investments. Part of the reason for the FOMC targeting a set level of inflation (currently 2%) is that investors, consumers, and businesses benefit from a stable level of inflation. Unexpected inflation however, is cause for greater concern.
The most direct link between inflation and investment impact is with bond investments. If you buy a bond for $1,000 today and expect to receive a semi-annual coupon payment and the return of your principal investment in 5 years, you do not want a high level of inflation over the next 5 years. This is because if inflation is unexpected high, the $1,000 you receive in 5 years purchases fewer goods/services than $1,000 today, effectively, the purchasing power of the dollar falls. However, if inflation is consistent, bond investors can demand a higher coupon rate to help offset the impact of the inflation. This is why inflation and bond yields are highly correlated.
Inflation also impacts stock investments; however, the impact is more mixed. In general, because a stock investment is the partial ownership of a business which often owns hard assets (such as factories and production equipment), inflation causes those assets to appreciate in price. Thus, stock investors have built-in protection against inflation via these assets. However, there is a counter-side to this. Inflation can cause volatility in earnings due to the potential for price increases in a business’s supply chain and their ability to pass-through those price increases to their customers. If they cannot pass through those increases, their earnings are impacted. This is what can cause valuations for companies to fall during periods of volatile inflation. Investors won’t pay as much for a company if the earnings could be negatively impacted by inflation. This is commonly observed through lower price-to-earnings (P/E) ratios during periods of volatile inflation. For a given level of earnings (E), the market pays a lower price (P).
In closing, while we’ve benefited from a period of low and consistent inflation over the past two decades, investors will be best served by paying close attention to inflation over the coming years. With the stimulative monetary and fiscal policies since the Global Financial Crisis, which continue today, the risk of unexpected inflation is rising. We recommend watching closely the change in inflation indices such as PCE and PPI to gauge current levels of inflation as well as wage growth as it is a strong indicator of the potential for future inflation.
Ironstream Capital, LLC is a registered investment adviser in the State of Washington and the State of Alaska. Ironstream Capital, LLC may not transact business in states where it is not appropriately registered, excluded, or exempted from registration. Individualized responses to persons which involve either the effecting of transaction in securities or the rendering of personalized investment advice for compensation, will not be made without registration or exemption.
The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell, or hold any security, investment strategy or market sector. No forecasts can be guaranteed. Opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. Is it not intended to indicate or imply that any illustration/example mentioned is now or was ever held in any portfolio. Past performance is no guarantee of future results. Investing involves risk, including the possible loss of principal and fluctuation of value.