LEVEL: BEGINNER
Inflation risk is the chance that the value of income or specific assets decline in value as other prices increase which erodes the purchasing power of a currency. Inflation causes currency to decrease in value at a specific rate.
Inflation
Inflation itself is the notion that a value of a basket of goods or services increases in value, decreasing discretionary income of consumers. The most notable types of inflationary assets are food and energy prices which are generally excluded from the core inflation reported by the Federal Reserve. The bulk of core inflation includes rents, housing prices, and labor costs. If the prices of gasoline increase by 25% over the course of a year, the ability of a consumer to purchase discretionary items will decline, if their ability to cut down on gasoline purchases is not elastic.
The benchmark measure of inflation used by the Federal Reserve is Personal Consumption Expenditures. There are a number of other indices that are widely used including the Consumer Prices Index (CPI) and the GDP deflator.
Velocity of Money
Another sound description of inflation is the velocity of money. What generally causes prices to rise is a change of money from one party to another, in which the activity continues to perpetuate. The velocity of money is generally calculated through the money supply which begins to accelerate substantially as inflation starts to take hold. As can be seen in the chart below which show M2 money supply, which is a gauge of velocity, compared to the Consumer Price index, the two inflation gauges are relatively correlated.
*Source – Seeking Alpha
Fixed Income and Inflation
Inflation is one of the worst enemies of fixed income assets. As prices rise on everyday items, it erodes the cash flows received by an investor. For example, $1,000,000 in bonds with a 5% coupon might generate enough interest payments for a retiree to live on, but with an annual 4% inflation rate, every $1,000 produced by the portfolio will only be worth $960 and will continue to erode if inflation rises. The rising inflation means that the interest payments have less and less purchasing power. And the principal, when it is repaid after several years, will buy substantially less than when the bonds were purchased.
Fighting Inflation
Throughout the history of the United States, inflation has changed in a mean reverting fashion, and has been kept in check by changes to interest rates. One of the dual mandates of the Federal Reserve Bank is to keep inflation is a specific range, targeting the most appropriate inflation levels for optimal growth.
When inflation expectations rise above the targeted level of the Federal Reserve, they tend to increase interest rates, which reduces the demand for lending and consumer activity. When inflation expectations decline, the Federal Reserve is more apt to keep rates low to increase growth and spur on employment.
The benefit of higher interest rates, beyond fighting inflation is that it increases the rates that banks will pay depositors. The negative aspect of rising interest rates is that it decreases the value of bonds, and other fixed income assets. Bond prices move in the opposite direction of their yields, so as rates increase, the value of a bond decreases. For investors that have money allocated to bonds, rising interest rates that are accompanied by increases in inflation is a double dose of bad news.
Equity prices are also generally sensitive to increases in interest rates. As interest rates increase, the discounted values of the cash flows of a company decrease making the price of a stock less valuable. During prolonged periods of increasing interest rates, stocks tend to underperform, although there are a number of sectors that benefit from inflation risks.
Stocks that Benefit From Inflation
Hard assets, such as gold, oil, and real-estate tend to benefit during times when inflation expectations are increasing. Homebuilding stocks tend to perform well at the beginning of an interest rate tightening cycle, as growth and labor market conditions favor a robust housing sector. Gold prices have always been considered a robust hedge against inflation, as the decline in the purchasing power of a currency generally does not have a negative impact in the demand for the yellow metal. Energy prices also tend to rise during times of strong growth in the early stages of a interest rate tightening cycle.
There are also a number of securities that attempt to address inflation risk by adjusting the cash flows for inflation to prevent changes in purchasing power. The majority of these products are fixed income products, or ETFs that replicate the payments of Treasury Inflation Protected Securities (TIPS). These types of securities adjust their coupon and principal payments for changes in the consumer price index, thereby giving the investor a guaranteed real return.
There are also a number of securities that handle the issue of changing rates by providing a variable rate as protection. For example, variable-rate securities provide some protection because their cash flows to the holder are based on indices such as LIBOR (London Interbank Borrowing Rate) that are directly or indirectly affected by inflation rates. Convertible bonds also offer some protection because they sometimes trade like bonds and sometimes trade like stocks.
Ramifications
Although inflation on a year over year basis has been relatively tame during the past 4 years, the issues related to inflation can be serious. An investor earns a lower return that he or she originally expected, in some cases causing the investor to withdraw some of a portfolio’s principal if they depend on that income. The most important issue to understand with regard to inflation risk isn’t the risk that there will be inflation; it is the risk that inflation will be higher than expected. Low interest rates over time will spur on inflation, but prices of financial instrument expect a certain amount of inflation. It’s when inflation is large than market participants expect that creates a adverse market move that could be painful to many investors.