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Perspectives

January 2022

Why We Might Be Scared About Inflation

 

Inflation is frightening. I know this from decades of living in the U.S., more so from decades of living in Israel before immigrating to the U.S. and decades of following its economics.

Fear is a useful emotion. It can lead us right when we recoil from a snake before checking whether the snake is poisonous or an offer that appears too good to be true. But when exaggerated, fear can lead us wrong and steer us away from taking prudent risks, whether immigrating to another country or investing some of our money in stocks.

We can exaggerate our fears through cognitive shortcuts that turn into errors. These include representativeness errors that mislead us into extrapolating recent events and availability errors that mislead us into focusing excessively on what is readily available in memory. We are wise to pause, gather information and reflect on these errors before we act on our fears, potentially imperiling our investments and diminishing our well-being.

Inflation in Israel accelerated in the 1970s—from 13% in 1971 to 111% in 1979, leaping to 191% in 1983 and 445% in 1984.1 A joke at the time said it was cheaper to take a taxi than a bus from Jerusalem to Tel Aviv because you pay bus fare when you board the bus but pay taxi fare with money diminished by inflation when you arrive at your destination an hour later.

But inflation in Israel was no joke, and some people tried to protect themselves through wasteful and costly methods, such as buying meat and canned goods that could be stored as soon as a paycheck arrived.

Eventually, the Israeli government was compelled to take drastic actions that tamed inflation at substantial costs, including the collapse of banks and subsequent government bailout of their small shareholders.

Inflation in the U.S. in the 1970s was no joke either, peaking at 14.8% in 1980. Here, too, the government was eventually compelled to take drastic actions. Paul Volcker, former chair of the Federal Reserve (Fed), effectively doubled the federal funds rate from just over 10% in early 1979 to nearly 20% in 1981.2 Inflation dropped to 3.2% in 1983 but taming it came at substantial costs—a recession and unemployment rate that exceeded 10%.

Cognitive Shortcuts and Errors Can Amplify Worries

This brings me to representativeness, the first of the relevant cognitive shortcuts and errors. Representativeness shortcuts involve assessing likelihood by similarity, such as extrapolating from the recent past into the future as if the future is sure to be like the recent past.

The recent bout of inflation is representative of high inflation, so we tend to conclude through representativeness shortcuts that high inflation will persist in the future. Yet this shortcut is likely an error.

First, inflation might decline on its own because of supply chain snags ironing out or consumers moderating their spending. Second, if inflation persists, mounting public pressure would lead the Fed to stop it, even at the cost of recession and high unemployment.

A good way to correct representativeness errors is by extending our representative period from one year to three years, five years or longer. For example, the inflation rate as measured by Ibbotson SBBI was 6.5% in 2021 (note that CPI was estimated at 7% over the same period), but average annualized inflation rates from Ibbotson SBBI during the three, five and 10 years ending in 2021 were much lower at 3.34%, 2.81% and 2.08%, respectively.

This brings me to availability, the second of the relevant cognitive shortcuts and errors. Availability shortcuts involve assessing likelihood by what is readily available to our memory. So, for example, a recent plane crash that dominates headlines makes plane crashes readily available to our memory, turning an availability shortcut into an availability error by inflating the likelihood of plane crashes.

Similarly, the high recent inflation that dominates headlines makes this topic readily available to our memory, turning an availability shortcut into an availability error by inflating the likelihood of high future inflation.

Now suppose a worst-case scenario where inflation persisted for years into the future despite ironed-out supply chains, diminished demand as stimulus payments ended and the Fed’s implementation of policy actions designed to moderate inflation. What then?

Distinguishing the Effects of Inflation on Income from Its Effects on Portfolios

Some income, such as Social Security benefits, is protected against inflation by indexation. Other income, such as salaries, is usually not protected, and indexing must be negotiated. Negotiations, however, are often unsuccessful, imposing great hardship.

Portfolio assets, however, may provide a hedge against inflation during both short and long periods. For example, the S&P 500® Index provided an annualized return of 10.46% over the 96 years spanning 1926-2021. It also provided a 7.36% inflation-adjusted annualized return during this period, implying that stocks provided ample mitigation against inflation over a long period.

Bonds also helped hedge against inflation during the 1926-2021 period. As measured by Ibbotson SSBI, the annualized returns of long-term Treasury bonds were 5.54% and 2.58% when adjusted for inflation. The corresponding annualized returns of long-term corporate bonds were 6.08% and 3.11%.

The same is true for the most recent 30-year period, 1992-2021. As measured by Ibbotson SSBI, the S&P 500 provided an annualized inflation-adjusted 8.11% return, long-term Treasury bonds provided an annualized inflation-adjusted 4.77% return and long-term corporate bonds provided an annualized inflation-adjusted 5.12% return.

Investing in commodities, such as energy, might offer a hedge against inflation during short periods than stocks and bonds. But concentrating portfolios in commodities would make them undiversified, thereby increasing risk, especially since commodity prices move up and down by effects distinct from inflation, such as actions by the OPEC oil cartel.

Still, unexpected inflation can negatively impact portfolios, especially bond returns. For example, in 2021, long-term Treasury bonds lost 5.41% and lost 11.14% on an inflation-adjusted basis. Allocations to inflation-linked bonds, such as Treasury Inflation-Protected Securities (TIPS), would have helped lessen these 2021 losses because TIPS automatically adjusts for inflation. This feature makes TIPs especially useful when seeking a hedge from inflation during short periods.

Yet TIPS are not always the best option. Like all Treasury securities, TIPS are subject to interest rate risk. In periods of rising interest rates and low or stable inflation, TIPS may lose value. Moreover, TIPS don’t offer the features of some other bonds—such as municipal bonds, which can offer tax-free income, or corporate bonds, which have typically offered a premium.

Build Diversified Portfolios and Pivot as Needed

Financial advisers can do well by clients by helping them recognize the benefits of fear and its harm when exaggerated. They can note that they know the power of exaggerated fear and sway of representativeness and availability errors but have learned to overcome them.

Keeping in mind clients’ particular circumstances and time horizons, clients who are saving for goals a decade or more in the future, such as retirement income, would likely benefit from a diversified portfolio of stocks and bonds to help provide risk management against inflation. Clients who know they will need to cash out portions of their portfolios in the next few years might consider keeping some portion in TIPs. If you are wondering how your portfolio may be impacted, it may be beneficial to speak with an adviser before taking any drastic actions.

Unless otherwise noted, all data cited in this article comes from Roger G. Ibbotson, SBBI® Dataset, Morningstar.

 


 

End Notes

1“Israel Business & Economy: The Rise & Fall of Inflation,” Jewish Virtual Library, 2011.

2“Federal Funds Effective Rate,” FRED Economic Data, Federal Reserve Bank of St. Louis.

 

Glossary

Consumer Price Index (CPI)
CPI is the most used statistic to measure inflation in the U.S. economy. Sometimes referred to as headline CPI, it reflects price changes from the consumer's perspective. It's a U.S. government (Bureau of Labor Statistics) index derived from detailed consumer spending information. Changes in CPI measure price changes in a market basket of consumer goods and services such as gas, food, clothing, and cars. Core CPI excludes food and energy prices, which tend to be volatile.

Hedge
An investment designed to reduce the risk of an adverse price move in another investment. Often a hedge consists of taking an offsetting position in a related investment.

Inflation
Inflation, sometimes referred to as headline inflation, reflects rising prices for consumer goods and services, or equivalently, a declining value of money. Core inflation excludes food and energy prices, which tend to be volatile.

Inflation-linked (or inflation-indexed) securities
Debt securities that offer returns adjusted for inflation, a feature designed to eliminate the inflation risk that has long been the bane of fixed-income investors. Typically, the principal of these securities is indexed to a widely used inflation measure or benchmark. U.S. Treasury inflation-protected securities (TIPS) are one popular form of inflation-linked securities.

Municipal bonds
These are long-term municipal securities with maturities of 10 years or longer.

Municipal securities (munis)
Debt securities typically issued by or on behalf of U.S. state and local governments, their agencies or authorities to raise money for a variety of public purposes, including financing for state and local governments as well as financing for specific projects and public facilities. In addition to their specific set of issuers, the defining characteristic of munis is their tax status. The interest income earned on most munis is exempt from federal income taxes. Interest payments are also generally exempt from state taxes if the bond owner resides within the state that issued the security. The same rule applies to local taxes. Another interesting characteristic of munis: Individuals, rather than institutions, make up the largest investor base. In part because of these characteristics, munis tend to have certain performance attributes, including higher after-tax returns than other fixed-income securities of comparable maturity and credit quality and low volatility relative to other fixed-income sectors. The two main types of munis are general obligation bonds (GOs) and revenue bonds. GOs are munis secured by the full faith and credit of the issuer and usually supported by the issuer's taxing power. Revenue bonds are secured by the charges tied to the use of the facilities financed by the bonds.

Treasury inflation-protected securities (TIPS)
TIPS are a special type of U.S. Treasury security designed to address a fundamental, long-standing fixed-income market issue: that the fixed interest payments and principal values at maturity of most fixed-income securities don't adjust for inflation. TIPS interest payments and principal values do. The adjustments include upward or downward changes to both principal and coupon interest based on inflation. TIPS are inflation-indexed; that is, tied to the U.S. government's Consumer Price Index (CPI). At maturity, TIPS are guaranteed by the U.S. government to return at least their initial $1,000 principal value, or that principal value adjusted for inflation, whichever amount is greater. In addition, as their principal values are adjusted for inflation, their interest payments also adjust.

 

This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice. 

 

Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

 

Diversification does not assure a profit, nor does it protect against loss of principal.

 

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