Inflation Explained - What It Is and How To “Hedge” Against It
Inflation fears are always lingering. Here we'll look at what inflation is, why it occurs, how it's measured, and the best assets to hedge against it.
Simply put, inflation refers to an aggregate increase in prices, commonly measured by the Consumer Price Index (CPI). Put another way, purchasing power decreases as inflation increases. This means that for any given unit of currency, in this case the U.S. Dollar, you're able to buy fewer goods and services as time goes on.
Average annual inflation in the United States is about 2%. This is why it's usually advisable to not hold a significant allocation to uninvested cash, as it's likely simply “losing to inflation.” This is especially true recently, as inflation has been much higher around 7%.
Inflation is illustrated in the stories your parents tell of being able to go the movies and get popcorn and a drink for 25 cents 40-50 years ago, whereas it's about 100x that today.
A central bank manages the money supply to attempt to keep inflation within a reasonable limit. This reasonable level of inflation is maintained because it encourages people to spend now, thereby promoting economic growth, rather than saving, as a dollar today is worth more than the same dollar tomorrow on average.
This somewhat constant level of inflation helps maintain price stability (think better planning for the future for both businesses and consumers) and is thought to maximize employment and economic well-being. Investors expect returns greater than this “reasonable,” average level of inflation, and workers expect wage increases to keep pace with the increasing cost of living.
How Is Inflation Measured?
Inflation is typically measured by two common statistics – the Consumer Price Index (CPI), a measure of the price in aggregate of consumer goods and services (e.g. food, apparel, education, etc.), and the Wholesale Price Index (WPI), a measure of the price of goods at the production level. Instead of the WPI, the United States uses a similar index called the Producter Price Index (PPI). CPI is used to measure cost of living.
All these are tracked, maintained, and reported by the U.S. Bureau of Labor Statistics. They report the CPI monthly going back to 1913. You can even narrow down CPI by region within the U.S.
When people reference the “inflation rate,” they're referring to the CPI.
Why Does Inflation Occur?
Inflation can occur as any of the following:
Demand-Pull Inflation: In short, demand exceeds supply, causing upward pressure on prices, also colloquially described as “too many dollars chasing too few goods.” Recall Keynesian economics and the supply vs. demand curve from microeconomics. Demand-pull inflation can be caused by things like a growing economy, an increase in the money supply, and an increase in government spending.
Cost-Push Inflation: Increases in wages and production costs (e.g. raw materials) necessarily drive prices up, while demand for goods and services stays constant or increases.
Built-In Inflation: Built-in inflation simply describes the fact that people expect inflation to continue to gradually rise, so firms continually raise prices to keep pace. Because of this increase in prices, consumers demand higher wages to keep up with a rising cost of living, which in turn causes firms to raise prices, and the cycle continues.
Annual Rate of Inflation Formula – How To Calculate
We can calculate the annual rate of inflation – or the change in prices for any time period – using CPI values with the following formula:
Inflation Rate = [(Final Index Value) / (Initial Index Value) - 1] * 100Here's an example. The annual CPI was 255.7 for 2019 and 258.8 for 2020. We can calculate the annual inflation rate like this:
Inflation Rate = (258.8 / 255.7 - 1) * 100 = 1.25%Similarly, we can see what the purchasing power of $1,000 in 1970 is in 2020 like this:
258.8 / 38.8 * $1,000 = 6.67 * $1,000 = $6,670Why Is Inflation Good?
Inflation can be good for owners of real assets like real estate and commodities, as a rise in their prices means they can be sold for a gain later. Of course, this benefits the owner/seller at the detriment of the buyer.
The aforementioned “reasonable” level of Inflation is generally also a sign of a healthy, growing economy, as it encourages more current spending and investment. This is why it's desirable to maintain that reasonable level of gradual inflation.
Why Is Inflation Bad?
As opposed to assets priced in the inflated currency, inflation eats away at the value of assets denominated in the inflated currency, such as cash and nominal bonds (particularly longer term bonds with more interest rate risk).
The prospect of variable or high/rapid inflation introduces uncertainty to both the economy and the stock market, which doesn't really benefit anyone. This uncertainty or variable inflation distorts asset pricing and wages at different times. Prices also tend to rise faster and earlier than wages, potentially contributing to economic contraction and possible recession.
How To Control Inflation with Monetary Policy
A country's monetary policy helps maintain “healthy” levels of inflation. In the U.S., that responsibility falls largely to the Federal Reserve Bank or simply “the Fed.” Again, the Fed attempts to keep inflation within reasonable limits in order to maximize employment, stabilize prices, and encourage spending. The main levers they can pull to achieve this are influencing interest rates and the money supply. A whole post (or a whole book) could be dedicated to this topic alone, but I'll keep it to a brief high-level summary.
Specifically, the Fed usually buys treasury bonds to inject cash into the economy, known as quantitative easing, or QE for short. The target rate of inflation in the U.S. is about 2%. QE is typically ramped up when interest rates are at or near zero, as the Fed then has fewer tools with which to act.
This is somewhat of a balancing act, though, as the Fed merely hopes to influence economic activity; it cannot force lenders and borrowers to do anything. Moreover, the Fed's increasing the money supply can lead to stagflation – inflation without economic growth – and a devalued currency, which makes imports more expensive. This itself can again drive up production costs and subsequent consumer prices, and thus inflation may accelerate beyond the Fed's target levels.
Inflation Examples
When people think of famous examples of inflation, they're almost always cases of hyperinflation, defined as an inflation rate of more than 50% per month. Hyperinflation is extremely rare in developed countries. Here are a few famous examples of hyperinflation throughout history:
Hungary – 1945-1946 – Hungary at one point saw daily inflation of 207% after the government tried to use inflation to restore the economy after World War II.
Zimbabwe – 2007-2008 – full-blown hyperinflation at a daily rate of 98% that followed many years of high inflation around 40% annually as a result of reckless government spending. Zimbabwe was forced to eventually abandon its currency altogether.
Yugoslavia – 1992-1994 – a result of the dismantling of trade following the breakup of Yugoslavia.
Greece – 1944 – a result of huge sovereign debt from World War II and tax revenues dwindling.
Germany – 1923 – Hyperinflation of the Weimar Republic is one of the most famous examples in history, resulting from the government basically printing money to pay war reparations.
Inflation Hedges – Do You Even Need Them?
People seem particularly concerned with “inflation” nowadays and how they can “hedge” against it. I put those words in quotes because when people discuss or fear “inflation” (and how to hedge against it), they usually mean above-average inflation. Remember, inflation per se is essentially always happening at a relatively steady rate that we hope stays around 2% per year (at least in the U.S.).
Financial pundits writing headlines about “inflation fears” are intrinsically referring to the prospect of inflation that is greater than or faster than the average rate. The important distinction I want to make is simply that any “hedge against inflation” one hopes to adopt is to mitigate the potential negative impact of unexpected, above-average inflation.
Why is this distinction important? Recall the Efficient Markets Hypothesis, the idea that all known information is already incorporated into the prices of assets. Many investors perhaps don't realize that the steady, constant, expected inflation we've discussed is already baked into the prices of stocks and bonds, so annual inflation continuing as it has does not necessarily hurt your portfolio, and you don't need a “hedge” (or portfolio protection) for it.
Moreover, know that an extended above-average inflationary environment in the U.S. is pretty rare. We haven't seen one since the 1970's, before the Volcker era when there was a fundamental shift in U.S. monetary policy. In fairness, we are currently seeing unprecedented levels of low bond yields and high stock valuations which could arguably contribute to a greater propensity for above-average inflation, but I'd be willing to bet that it would be short-lived.
Because of all this, arguably the best “hedge” for inflation is simply greater portfolio returns, usually achieved by a stocks-heavy portfolio, as stocks have the greatest expected returns of any asset class. That is, as with assets like gold, any dedicated allocation to an asset as a purported “inflation hedge” will likely simply drag down your long-term total return. More on this in a bit.
Moreover, any allocation taken up for that purpose should probably be relatively small, as again we're talking about a pretty unlikely scenario that will likely be short-lived. Don't miss the forest for the trees. I would submit that buy-and-hold investors with a long time horizon and a moderate to high risk tolerance should ignore the short-term noise anyway and likely don't need any dedicated position as an inflation hedge, despite what the fearmongering headlines from the pundits in the financial blogosphere say.
However, as usual, retirees or those with a short time horizon or low risk tolerance may find this typical tradeoff between risk (and specifically, short-term volatility) and return perfectly acceptable and desirable, and that's fine (and appropriate). Unexpected inflation can also be particularly damaging for these investors. The next section is for them.
Assets To Hedge Against Inflation
So for those who do want to specifically protect (“hedge”) their portfolio against above-average inflation, which assets are best? First, let's talk about what we're looking for and hoping to achieve with an “inflation hedge.”
Just as one might buy put options as a direct hedge for a bullish stocks position as somewhat of a short-term insurance policy if the investor fears an impending crash in the short-term, an ideal inflation hedge would increase in value to a greater degree than the CPI itself precisely when called upon, acting as an insurance policy against rapid rising inflation. Sounds great, right? Where do I sign?
Unfortunately, I've got some bad news: No such asset exists.
So the phrase “inflation hedge” is sort of a misnomer. Now you see why I said earlier that the ironic, perhaps counterintuitive answer for the “best inflation hedge” over the long term may just be plain ol' stocks (and a stable job), providing the greatest returns for your portfolio leading up to and following an inflationary period, thereby allowing your portfolio's value to weather future storms more easily. In that sense, you're likely already covered.
But we know that above-average inflation still devalues our uninvested cash and nominal bonds in the short term, which is an important consideration for the retiree due to sequence risk, and we also know risk is experienced over the short term. So what about assets that can keep pace with (match) the CPI or simply perform comparatively well during inflationary periods? Let's look at some options.
Real Estate
Inflation means higher prices for real assets, one of which is real estate. This means higher property values. Landlords can also directly pass on inflation costs to tenants in the form of higher rents. This applies to both physical property owners and REIT investors.
Though it's debatable, real estate may also offer a small diversification benefit to one's investment portfolio while not necessarily sacrificing returns.
VNQ is a popular REITs ETF from Vanguard.
Commodities
Similarly, commodities are a tangible asset as well. Commodities are simply means of production – oil, gas, copper livestock, etc. Just like with real estate, the value of these things goes up with inflation.
However, commodities are not a value-producing asset so they have a long-term expected real return of about zero, commodities funds are expensive, and there are better alternatives for inflation-protected assets in my opinion.
The legendary Ken French maintains a similar position:
“The claims that, going forward, commodity funds (i) will have the same Sharpe ratio as the stock market, (ii) will be negatively correlated with the returns on stocks and bonds, and (iii) will be a good hedge against inflation can't all be true. Who would want the other side of this trade? The high volatility of commodity prices makes it impossible to accurately estimate the expected returns, volatilities, and covariances of commodity funds, but theory suggests that if commodity returns are negatively correlated with the rest of the market, the expected risk premium on commodities is small, perhaps negative. Finally, commodity funds are poor inflation hedges. Most of the variation in commodity prices is unrelated to inflation. In fact, commodity indices are typically 10 to 15 times more volatile than inflation. As a result, investors who use commodity funds to hedge inflation almost certainly increase the risk of their portfolios.”
Gold
While we're on the subject of commodities, the most popular one is gold. The shiny metal is often touted as an inflation hedge, but unfortunately it hasn't been a reliable one historically.
Just like broad commodities, gold is also not a value-producing asset, so we wouldn't expect it to generate a return over the long term. Remember what I said about an inflation protection asset likely simply dragging down the returns of the portfolio over the long term. Gold is also taxed as a collectible.
I would submit that gold has no place in a long-term investment portfolio unless the investor is very risk-averse and simply wants to minimize volatility and drawdowns, as gold does tend to be uncorrelated to both stocks and bonds.
Stocks
As I've already said, stocks are a great inflation “hedge” simply due to their greater expected returns over the long term, not because they tend to do well during periods of high unexpected inflation (they don't). Specifically too, “defensive” sectors like Consumer Staples and Utilities tend to weather inflationary and recessionary periods better than others, as public demand for these goods and services typically remains unchanged (which is why they're called non-cyclical).
Value stocks in general tend to beat Growth stocks during these periods as well.
As usual, this is also a case for global diversification in stocks, as one country's inflation issues may not affect another.
Debt
Purchasing power decreases with inflation because the value of the currency drops, but this also means that any nominal debt you have is now worth less in real terms. Periods of above-average inflation are a great time to have a mortgage.
Short-Term Bonds
I thought you said inflation hurts nominal bonds! Yes, but not all bonds are created equal. Short-term bonds are less sensitive to interest rate changes because you can quickly roll them over into new bonds at higher yields after they mature, and a bond held to maturity should return its par value plus interest.
T Bills (ultra short term treasury bonds of 0-3 month maturities) even essentially kept pace with inflation during the double-digit inflation of the 1970's in the U.S.! There have also been plenty of periods where 1-month T Bills outperformed the stock market. While T Bills are quite literally the “risk-free asset,” they're no slouch. We would expect their returns to be slightly higher than inflation, and indeed they have been historically. The annualized historical return of 3-month T Bills from 1928-2020 was 3.32%. The average inflation rate over that period was 3.02%, which means a real return (return adjusted for inflation) of 0.3%.
While we wouldn't want to hold a significant allocation in cash equivalents over the long term, they provide a decent buffer over the short term for unexpected inflation.
TIPS
The only asset truly linked to inflation is a relatively new financial product called Treasury Inflation Protected Securities, or TIPS for short, which launched in the U.S. in 1997.
In short, TIPS are U.S. Treasury bonds that are indexed to the CPI, so they rise in tandem. This is precisely what we want in an inflation protection asset. The tradeoff, of course, is their limited long term return. If inflation matches or is lower than aggregate investor expectations, TIPS will have lower returns than nominal bonds. If inflation is higher than expected, TIPS will have higher returns than nominal bonds.
Unfortunately TIPS did not exist in the U.S. during the runaway inflation period of the late '70s, but one can look at the last couple years of above-average inflation (2020-2021) to see TIPS doing their job.
A general rule of thumb for a retiree is to consider putting at least half of their fixed income allocation in TIPS, as high unexpected inflation can be disastrous for the retiree's portfolio, from which withdrawals are being made regularly to cover expenses and to which no new deposits are flowing.
It's worth noting though that TIPS do not seem to exhibit the same “crisis alpha” (i.e. “flight to safety” behavior) that nominal treasury bonds do during stock market crashes. The retiree should also probably have a decent allocation to short- or intermediate-term nominal bonds.
TIPS obviously become more important for retirees and those with a bond-heavy portfolio, and are less attractive for younger investors with a long time horizon.
Conclusion
Inflation is always happening, hopefully at a steady rate, kept on the rails by a central bank. This expected inflation is already incorporated into asset prices. What we're concerned with possibly protecting against is unexpected above-average inflation.
Even then, an investor with a long time horizon and a high tolerance for risk – and subsequently, a high allocation to stocks – likely shouldn't be worried about short-term inflation. However, it's perfectly suitable and even desirable for retirees, risk-averse investors, and those with a short time horizon to have some allocation to inflation-protected assets like TIPS.
While it may go against what you've heard, commodities and gold may not be great assets to save your portfolio from runaway inflation in the future, and are almost certainly suboptimal investments over the long term. I would submit that investors will likely come out ahead using assets like REITs, short-term nominal bonds, and TIPS. I'm not a fan of sector bets (they're just stock picking lite), but it may also be prudent to slightly overweight “defensive” sectors like Consumer Staples and Utilities if one fears inflation (or any market turmoil, for that matter).
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