Investing in Inflationary Times

LESSON 1 Inflation
Introduction
Inflation Outlook
Inflationary Environments
Theoretical Causes of Inflation
Breakeven Inflation Rate
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Lesson 1 Inflation

Introduction
It is not certain that an inflationary environment is on the horizon, but we can not ignore the risk that it
will happen. In this lesson, you will learn about the causes of inflation, so that you will be better prepared
to re-evaluate your clients’ portfolios in that context.
When you have completed this lesson, you should be able to meet the following objectives:
» Discuss the factors currently driving inflation.
» Compare the different inflationary environments.
» Discuss the Keynesian and monetarist theories of inflation.
» Explain the breakeven inflation rate.

Inflation Outlook
Today, most market participants are not old enough to remember the inflation spikes in the 1970s
and very early 1980s, but those who do will recall how serious an issue it was. Many businesses were
undermined, and many individuals faced financial hardship. Inflation in the United States peaked at just
over a 14 percent annualized rate in 1980. That inflationary cycle was brought under control over the
ensuing four or five years by the very restrictive monetary policy implemented by the Paul Volker-led
Federal Reserve (“the Fed”). Since that time, investors have mostly dealt with a 2-to-3% annualized
inflation rate. As a result, many investors today do not have first-hand experience dealing with the
investment challenges associated with steep inflation.
As of August 2021, Canada appears to be emerging from the third wave of the Covid-19 pandemic. By
January 2021, the S&P/TSX Index had not only fully recovered from its pandemic-related panic-lows
in March 2020 but continued its ascent to set numerous record highs during the first half of 2021. The
increasing optimism that the worst of the pandemic was behind us, and the sharp rebound in gross
domestic product figures released during the first half of 2021, helped to propel the stock market upward.
Over the same period, bond yields rapidly declined to record low levels by June 2020 as many central
banks, including the Fed and the Bank of Canada, implemented aggressive monetary easing programs.
These measures flooded the banking system with ample liquidity to help minimize the potential damage
the Covid-19-related shutdowns could inflict on the economy. However, bond yields did increase
somewhat over the following year, likely in recognition that an economic recovery was underway.
The rising yields seemed to reflect investors’ anticipation that central banks were approaching their
economic and inflation-related targets and that they would start to wind down their monetary easing
strategies. However, in spring 2021, the fear of rising inflation began to creep into the financial press
and investors’ minds.

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The fear of inflation is most often attributed to the five factors discussed below.
» Monetarist views of the central banks’ response to Covid-19
In 2021, the central banks have continued their aggressive easing to help nurture a strong economic
rebound and create employment opportunities for many of the millions who lost their jobs during the
economic shutdown.
Investors were already uneasy about the potential inflationary impact of the dramatic growth of
central bank balance sheets that occurred after the 2008 financial crisis until 2018. They became
increasingly concerned because of the material growth of those balance sheets that occurred during
the first half of 2020.
Figure 1.1 shows the growth of the Fed’s balance sheet from 2007 to mid-2021. It puts into perspective
the relative size of the central banks’ monetary response to the Covid-19 crisis in 2020 in relation
to the historic level of monetary easing that occurred in 2008. This growth added more fuel to the
monetarists’ view that the risk of inflation was now even greater.

FIGURE 1.1 FEDERAL RESERVE BALANCE SHEET

8T
7T
6T
5T
4T
3T
2T
1T
0
00 01 02 03 04 05 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21
Total Assets (In trillions of dollars)

Source: Federal Reserve

» Fiscal policy
Extreme fiscal stimulus has been implemented alongside the aggressive monetary stimulus discussed
earlier. The actual and proposed U.S. federal government spending programs are enormous relative
to all prior federal spending programs. There are concerns that this elevated level of fiscal stimulus
applied over a relatively short period will push the economy closer to optimal capacity faster, which
could lead to an overheated economy and a corresponding increase in inflation.
Note that monetary policy, as discussed above, and fiscal policy are currently connected. The
aggressive level of monetary stimulus involves the continued use of quantitative easing to fund the
vast majority share of the federal government’s spending plans, both during and immediately after
the Covid-19 crisis.

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» Raw material price increases

Almost all commodity sectors have seen dramatic increases in the price of raw materials since the
second half of 2020. Market participants are concerned that these higher input costs will impact the
prices paid by manufacturers and, in turn, consumers, thereby eventually inflating the Producer Price
Index (PPI) and Consumer Price Index (CPI).

» Logistical bottlenecks
One unique and unexpected consequence of the Covid-19 crisis is that some major challenges now
prevail in the global shipping business. Almost every day, companies are announcing shortages of parts
and finished goods, usually because of the inability to obtain deliveries on pre-Covid-19 timelines
due to a current shortage of sea-going container capacity. Furthermore, many logistical and shipping
companies are warning their customers that restricted global shipping conditions might prevail into
late 2021 or early 2022. The resulting inventory shortages occurring during periods of high consumer
demand can contribute to inflation in that they can cause manufacturing and consumer prices to rise.

» U.S. Consumer Price Index statistics

Even with many of the above factors in place for several months prior, many investors were shocked
to see the U.S. CPI statistics released for the months of March, April, and May of 2021. The May
release indicated that consumer prices rose 5.0% year-over-year (the fastest pace since August 2008),
which was much higher than most investors’ expectations of approximately 3.5%. In addition, the
accompanying 3.8% rise in the core inflation rate for May, which excludes food and energy prices, was
the largest year-over-year increase in almost 30 years.

The five factors discussed have led many investors to question how their current portfolios and
investment strategies will perform if the recent rising inflation trend does not turn out to be transitory,
as the Fed and the Bank of Canada have recently suggested. Depending on the answer, investors must
understand how to modify their portfolios to offer the best protection against inflation given their risk
profile and investment goals.
To properly analyze an investor’s current portfolio and make appropriate modifications to accommodate
the changes to their inflation-related expectation, two critical pieces of information are required:
» How do individual asset classes perform in an inflationary environment?
» Within each asset class, which specific investments and investment strategies offer the best hedge
against future inflation?

In Lessons 2 and 3, we provide answers to these two important questions.

Inflationary Environments
Inflation is commonly defined as a general increase in prices or a decrease in the purchasing power of
money. In a period of rising inflation, goods and services cost more overall because the purchasing power
of money has declined.

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Economists and investment strategists generally define various inflationary environments in terms of the
inflation rate and the expected direction of change. Table 1.1 lists and briefly describes the four inflationary
environments most frequently used in the analysis.

TABLE 1.1 INFLATIONARY ENVIRONMENTS

Rate and Direction of Inflation

Inflation Positive inflation rate where the rate is above the long-term trend
Reflation Positive inflation rate where the rate is below the long-term trend
Deflation Decreasing inflation rate where the rate falls below zero
Disinflation Slowing inflation where the rate is still above zero

The four inflationary environments are often considered collectively. They are connected sequentially;
they follow one another in a somewhat cyclical manner, and they are generally linked directly to a specific
point in the economic cycle.
In general, advisors first develop an economic outlook and then adopt the inflation outlook that
historically accompanies the anticipated economic outlook. In other words, the inflation outlook follows
directly from the anticipated economic outlook.
Although the four inflationary environments represent most inflation scenarios, historically, two
additional environments come under consideration when required. These are defined in table 1.2.

TABLE 1.2 STAGFLATION AND HYPERINFLATION

» High inflation rate

Stagflation
» Slowing rate of economic growth
Hyperinflation » Extremely high inflation rate (defined as greater than 50% per month)
» Occurs infrequently
» Generally limited to third-world economies

Many economists view the 1972 to 1982 period as a stagflation environment for most western economies.
Stagflation is primarily attributed in this case to the combination of high inflation brought on by the two
Arab oil embargoes in the 1970s coupled with the accompanying sub-par economic growth that resulted.
The potential for stagflation in western economies has become a greater concern recently. Some analysts
fear that the aggressive fiscal and monetary policies applied during the Covid-19 crisis will result in high
inflation accompanied by slower economic growth.
Hyperinflation is frequently associated with the Weimar Republic in the early 1920s. However, a more
recent example is Venezuela, where the country’s central bank estimated that the inflation rate exceeded
53,000,000% between 2016 and 2019.

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Theoretical Causes of Inflation

The cause or causes of inflation is one of the most pursued topics in economic and financial academia, and
there is a continuous stream of new research being published. The two foundational and most popular
theories of inflation are the Keynesian view and the monetarist view.

KEYNESIAN VIEW OF INFLATION

The Keynesian view of inflation is that it happens when aggregate demand is greater than aggregate
supply and that the money supply plays no role over the short- to medium-term. This theory is generally
explained in terms of two scenarios:
» Demand-pull effect
Demand-pull inflation is driven by consumers and occurs when aggregate demand is greater than
aggregate supply. In this scenario, prices rise due to an increased demand for a product, and consumers
are willing to pay the higher prices. Over time, manufacturers will produce additional supply if it is
profitable to do so. The amount of additional supply will continue to grow until supply equals demand,
at which point the product’s price stabilizes.

» Supply-push effect
Supply-push inflation is driven by producers and occurs when profit margins narrow due to a higher
cost of production. Supply will go down if producers cannot make as much profit at current prices, so
the producers pass the increased cost of production on to consumers. In this scenario, inflation occurs
when prices increase so that producers can meet demand profitably.

MONETARIST VIEW OF INFLATION

The monetarist view of inflation (originated by U.S. economist Milton Friedman) assumes the most
significant factor influencing inflation is the rate at which the money supply grows. Briefly, its
foundational belief (i.e., the quantity theory of money) is that a change in the amount of money in a
system will change the price level in that system. Furthermore, it states that fiscal policy is not effective
at controlling inflation.
However, one of the most perplexing current issues regarding the monetarist view is that the rampant
growth of the money supply has not resulted in an inflationary environment, as postulated by the theory.
It is especially puzzling in terms of the Fed’s M2 measure, which is a broader component of the money
supply that includes cash, checking deposits, savings deposits, and money market securities. The growth of
the money supply was brought on by multiple large amounts of monetary easing (via quantitative easing)
and associated fiscal spending in response to both the 2008 financial crisis and the Covid-19 crisis.
One frequently promoted explanation centres on an examination of the money supply growth in relation
to the velocity of money (i.e., the number of times the money supply has passed through the U.S.
economy) over the same period. This data is provided by figure 1.2, which depicts the year-over-year rate
of change of the M2 money supply measure and the velocity of money figure for the 2000 – 2020 period.
One interpretation is that, although the M2 money supply has grown dramatically (which would normally
have an inflationary effect), the circulation of money through the economy has drifted lower and lower.
Thus, there is less money chasing goods and services and therefore less upward pressure on inflation.

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FIGURE 1.2 MONEY SUPPLY AND MONETARY VELOCITY

24,000 2.2

20,000 2
Billions of Dollars

16,000 1.8

Velocity of M2
12,000 1.6

8,000 1.4

4,000 1.2

0 1
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 End

Velocity of Money Stock M2 Money Stock

Source: Federal Reserve Bank of St. Louis, Velocity of M2 Money Stock [M2V], retrieved from FRED, Federal Reserve
Bank of St. Louis; https://fred.stlouisfed.org/series/M2V, August 19, 2021.
Source: Board of Governors of the Federal Reserve System (US), M2 Money Stock [M2SL], retrieved from FRED, Federal
Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/M2SL, August 19, 2021.

Additionally, some economists have recently postulated that a growing portion of the money supply
has been directed to investments, thereby propelling the stock, bond, and real estate markets higher.
A proportionally smaller amount of the new money supply is ending up in the hands of individuals to
be used for purchases that support the real economy. The potential for upward pressure on the prices of
goods and services, which represent a very large portion of the items that constitute the PPI and CPI, is
therefore diminished.

Breakeven Inflation Rate

The breakeven inflation rate is defined as the difference between the yield of a nominal U.S. Treasury
Security and that of a U.S. Treasury Inflation-Protected Security (TIPS) of the same maturity. The
difference is calculated as follows:

Breakeven inflation rate = YTM on Nominal U.S. T-Bond – Yield on U.S. TIPS

In Canada, the equivalent calculation uses the Government of Canada nominal bond yield and the
Government of Canada Real Return Bond (RRB) yield of the same maturity.

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The primary purpose of the breakeven inflation rate is to provide an indication of the expected future path
of inflation as perceived by bond and money market participants. Breakeven inflation rates are calculated
along the entire U.S. Treasury yield curve, with the most frequently used securities being the 2-year,
5-year, and 10-year maturity versions.
While the absolute value of the breakeven inflation rate is important, the recent path and direction of that
rate is also a critical factor. The recent path is generally interpreted to mean that inflation expectations
will increase if it slopes upward and will decline if it slopes downward.
Figure 1.3 provides the breakeven inflation rate between the 5-year maturity U.S. Treasury bond and
the 5-year maturity U.S. TIPS. The U.S. breakeven inflation rate has a relatively short history given that
TIPS were first issued in January 1997. Because Canadian government RRBs were first issued in 1991, the
Canadian breakeven inflation rate has a slightly longer history.

FIGURE 1.3

1
Percent

-1

-2

-3
2004 2006 2008 2010 2012 2014 2016 2018 2020

Source: Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE], retrieved from FRED, Federal
Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/T5YIE, August 19, 2021.

FEDERAL RESERVE – INFLATION TARGETING

Prior to 2012, the Fed clearly communicated that one of its primary monetary policy objectives was to
ensure price stability in the domestic economy, a measure commonly referred to as inflation targeting.
However, a problem with inflation targeting is that the specific inflation rate set as the numerical target
was not part of the Fed’s communiques. Economists and market strategists were therefore left with the
task of guessing at the level of inflation that would cause the Fed to change from an easing stance to a
tightening stance or vice versa. (At the time, it was believed that the inflation target was somewhere
between 1.7% to 2.0%.)

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In January 2012, the Fed announced for the first time ever that its explicit target inflation rate was 2.0%, as
measured by the personal consumption expenditures price index. This target remained in place until 2020.
That approach changed again in August 2020 when the Fed announced that its 2% target inflation rate
was being replaced with an average inflation rate target of 2% over the long term. Not surprisingly, this
new approach is referred to as average inflation targeting and remains in place currently.
The good news for investors is that they now know the average inflation rate around which the policy is
managed. However, the Fed has provided no information regarding the maximum acceptable range, either
above or below the 2% average figure, that will be tolerated by the Fed or for how long they will tolerate
the deviation before they change the direction of their monetary policy.
Thus far, we have discussed fundamental factors behind inflation. In Lesson 2, we examine fixed income
and equity investments and explain how they perform in an inflationary environment.

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