by Joseph Becker
Joseph Becker is the manager of education marketing for Invesco PowerShares Capital Management LLC, where he is responsible for the creation of content for educational materials for institutional and retail investors. For additional information, call (800) 983-0903 or e-mail info@powershares.com.
At the onset of 2010, even as many of the economic issues of 2008
and 2009 were still being worked out, there were some indications
that the economy had troughed and that the greatest threats to the
stability of the financial system had subsided. By their very
nature however, such cataclysmic financial events are difficult, if
not impossible, to foresee, and only time will reveal whether
another looms on the horizon.
As these recent events remain fresh on our minds, financial advisers need to be vigilant and develop strategies for risk management. The risk of inflation remains a subtle yet corrosive underlying current that all economic participants should understand.
This article is intended to provide a context in which to think about and understand inflation along with some of its implications for saving and investing.
What Is Inflation and How Is It Measured?
Inflation is generally defined as a continuing rise in the general price level usually attributed to an increase in the volume of money and credit available relative to the supply of goods and services. The most commonly used and referenced numbers on inflation come from the U.S. Bureau of Labor Statistics (BLS). The BLS publishes the change in its consumer price index (CPI) each month and offers index values dating back to 1913. The changes in this index are used to calculate the rate of inflation.
The CPI is comprised of the prices paid by consumers for a representative basket of goods and services. As of the end of 2009, the basket consisted of fixed amounts for the following items:
|
Electricity |
Utility gas |
Fuel oil |
Gasoline |
Bread |
|
Ground beef |
Chicken |
Eggs |
Milk |
Apples |
|
Oranges |
Bananas |
Tomatoes |
Orange juice |
Coffee |
What Causes Inflation?
Understanding the cause of inflation first requires an understanding of money and its function in an economy. In the absence of money, consumers and producers would operate in a barter economy where they would exchange goods and services for other goods and services. This is why money is sometimes referred to as a medium of exchange. The use of money avoids the inefficiencies of a barter system, such as the double coincidence of wants problem, and increases the ability of economic participants to exchange their goods and services by expanding their market to include anyone who has money. In this sense, money serves as a unit of value to facilitate exchange; or put another way, it is the oil that greases the gears of the economic engine.
A Monetary Phenomenon
Inflation in the purest sense has everything to do with the value of money. Nobel laureate Milton Friedman is known for having stated, "Inflation is always and everywhere a monetary phenomenon." In other words, inflationary price increases are meant to be understood as a decrease in the value of money, rather than an increase in the value of the things to which prices are connected.
In this context, money can be thought of much like any other commodity, subject to the laws of supply and demand. The supply of money is generally understood as the amount of currency and credit in an economy, while the demand for money is essentially a function of an economy's propensity to exchange goods and services. When the supply of money exceeds the demand for money, its value will adjust downward until the market for money moves back into equilibrium. This adjustment in value is reflected in higher price levels.
Is Higher Inflation on the Horizon?
The dynamic nature of the market for money can make it difficult for even the best economists and financial analysts to predict future rates of inflation. That difficulty notwithstanding, it can be helpful for advisers to be aware of historical inflation trends and to understand how markets signal their expectations of inflation.
Since 1914 through the end of 2009, the annualized rate of inflation measured monthly has averaged 3.39 percent.
Figure 1: CPI Changes From 1914 to 2009
Source: Federal Reserve Bank of St. Louis, as of December 31, 2009
As indicated in Figure 1, the Consumer Price Index's (CPI) average
rate of change was much less volatile after 1955, but was also
higher and remained in positive territory until March 2009.
Naturally, the past is no guarantee of the future, but knowing the
circumstances surrounding periods of higher inflation may provide
valuable insight into the potential for future inflation.
Money: GDP
As noted earlier, inflation occurs when the supply of money exceeds the demand for money. Given that money is a facilitator of economic activity, one of the broadest indicators of the demand for money is the level of economic activity measured by gross domestic product (GDP). As such, changes in the ratio of money to GDP can be a signal of potential inflationary pressures. Figure 2 shows the historical ratio between M2 (a broad measure of the amount of money in circulation) and GDP.
Figure 2: Historical Ratio Between M2 and GDP
Source: Federal Reserve Bank of St. Louis, as of December 31, 2009
Figure 2 indicates that after peaking in 1965, M2/GDP began a
30-year downward trend that bottomed in 1997. Since then, M2/GDP
has been on an upward trend that accelerated during the difficult
economic environment of 2008 and 2009. It is interesting to note
that in 2009, the gap between M2/GDP and the rate of inflation
reached 61 percent. The only time during the previous 50 years that
it was higher than 61 percent was in the early 1960s, a period that
was followed by 15 years of significant inflation.
Inflation Expectations
One way that markets display their expectations of inflation is through interest rates-particularly through the difference in the yields of Treasury bonds and Treasury Inflation Protected Securities (TIPS). Like the yield of any other fixed income security, Treasury yields are generally determined by two primary factors: credit risk and inflation expectations. As these factors rise, investors will require additional compensation in the form of a higher yield.
TIPS, however, are structured to increase their principal amount in direct proportion to changes in the CPI. This has the effect of compensating investors for inflation and eliminating the requirement of a higher yield. Given that TIPS have the exact same credit risk as ordinary Treasury bonds, the yield difference between the two can be attributed entirely to inflation expectations.
At the end of 2009, the 10-year Treasury yielded 3.59 percent, while the 10-year TIPS yielded 1.36 percent. Subtracting the TIPS yield from the Treasury yield reveals the bond market's expectation of inflation over the next 10 years: 3.59 percent (Treasury bond) - 1.36 percent (TIPS) = 2.23 percent. Figure 3 displays this relationship dating back to the beginning of 2003.
Figure 3: TIPS Spread (%)
Source: Federal Reserve Bank of St. Louis, as of December 31, 2009
Monitoring the TIPS spread may be a useful practice for advisers
who are particularly concerned about being vigilant of the prospect
for higher inflation.
For investors who think that higher inflation may be on the horizon, there are asset classes that have historically proven to be a useful hedge against the dilution of the dollar's value and potentially gain purchasing power. Gold, commodities, and real estate are all investable assets that may benefit from rising inflation. Exchange-traded funds (ETFs) may be useful tools for advisers interested in allocating these assets to client portfolios.
Using ETFs to Hedge Inflation
Gold is often categorized under the commodities umbrella, but it might be more accurately classified as a currency, because it has been used as a medium exchange for centuries. Gold also offers several valuable physical properties such as conductivity, malleability, and resistance to corrosion. While copper shares similar physical properties, the price of gold is more than 50 times the price of copper, which suggests there is more to the value of gold than simply its physical properties. Gold is attractive as a hard asset investment capable of maintaining value relative to a paper currency.
Gold has historically been one of the most popular choices for investors seeking to hedge against inflation, and with the increasing availability of ETFs, gaining access to the gold market may be easier. Several types of ETFs are available that track the gold market in different ways. Some ETFs buy and hold gold bullion in order to track the price. A second type of ETF tracks the price of gold through holding gold future contracts. A third type of ETF invests in companies that specialize in mining and producing gold. While this final group of ETFs offers a less direct means of tracking the price of gold, historically there has been a good correlation between gold producers and the price of gold.
Commodities make up another asset class that is highly price-sensitive. The usefulness and scarcity of commodities helps to maintain their value both relative to each other and apart from their price in terms of dollars. For this reason, they are generally considered a good hedge against inflation. As the price of consumer goods rises, commodities prices typically rise as well.
ETFs also provide investors access a wide array of commodity markets. The range of ETFs available includes broad access to the most heavily traded physical commodities in the world, access to narrower segments such as just agricultural, and individual commodity holdings such as oil, copper, or sugar.
Real estate exhibits some of the same characteristics that make gold and commodities a suitable inflation hedge, but it is also vulnerable to other economic factors that can influence the price. Because inflation contributes to higher interest rates, it can also decrease demand from borrowers and investors for real estate, providing a dampening effect. As a hard asset however, real estate's value will usually rise against a falling dollar.
One way investors can invest in real estate is through a real estate investment trust (REIT). REITs can be publicly traded on exchanges or privately held. ETFs have made it possible to invest in a broad portfolio of REITs using a basket approach. Some ETFs also allow for more precise access to regional areas such as the United States, Europe, and Asia. Other ETFs are more targeted, breaking down into segments such as office, industrial, retail, or residential properties. Real estate ETFs provide investors with current income and a viable option to hedge against inflation.
While inflation expectations, particularly in the United States, have been moderate in recent years, the recent economic crisis poses many problems for the Federal Reserve, including record high U.S. government debt, low interest rates, and a huge boost to the monetary base over the past year. Investors have good reason to be nervous about the value of the U.S. dollar and the prospect for inflation. The best time to prepare for inflation is before it becomes an obvious trend.
Editor's Note
This article is part of a Trends in Investing Special
Report from the June 2010 Journal of Financial Planning.
For complete coverage of the Special Report, visit www.FPAjournal.org/CurrentIssue/Supplements.
