When people discuss the economy, inflation is always part of the conversation, and it’s typically a pain point. Consumers tend to hate it and the Federal Reserve usually fears it. But what exactly does inflation mean for you, the investor?
Simply put, inflation is the sustained increase in the general level of prices for goods and services. As inflation rises, every dollar you own buys a smaller percentage of a product. For example, in the 1930s, you could buy a loaf of bread for $0.15 or a house for $5,000, but in the twenty-first century, those prices seem almost comical. That’s inflation; prices rise and the value of money falls.1
Gauging the inflation gauges
At its core, the difference between two key inflation metrics is simple: the price index for Personal Consumption Expenditure (PCE) is based on surveys of what businesses are selling. The Consumer Price Index, or CPI, is based on surveys of what households are actually buying. However, this difference highlights two key points: their weight and scope effects.
When it comes to weight differences, PCE is a broader measure that covers movements in economic activity. Overall, it’s not as sensitive to certain sectors like housing. The issue here is that sectors like housing may preview economy-wide inflationary environments. For example, roughly 33 percent of CPI is weighted to housing, while the weight of shelter is just 16.4 percent in PCE.2
Scope differences are an even more important factor. Take healthcare for instance. Typically medical care is not paid out-of-pocket by consumers. Instead, it’s partially paid by employers to cover insurance premiums or partially covered by the government through Medicare and Medicaid. But Medicare and Medicaid have different market dynamics than the services directly available to consumers, such as what’s sold through the healthcare exchange at healthcare.gov. Medicare and Medicaid are not market based. Those costs are adjusted by the government, and therefore, using those metrics as a measure of activity can mute the overall view of the market. Scope differences like these can account for the systematic divergence between PCE and CPI.
So is PCE accurately reflecting today’s inflationary environment? It has definite flaws that make it much more conservative in the pick-up of inflation and deflation. For example, CPI picked up the extreme deflationary environment post-Recession, when PCE didn’t.
And as you can see, unlike PCE, CPI is now showing a rise in inflation since early 2017. This may be something to keep a closer eye on in 2018.
Looking at other underlying data
Besides PCE and CPI, there are numerous other data points that can help to predict inflation. One such example is the New York Fed’s Underlying Inflation Gauge, which includes the value of financial assets, and therefore captures a more robust picture of the economy. Recently the metric registered an 11-year high of 3 percent. This data point may suggest both inflation and interest rate hikes are about to accelerate.
We can also take a look at wage growth as an indicator. Our economy is expanding and near full employment, helping drive up wages. In December 2017, we saw a 2.98 percent increase in wages from December 2016, the highest year-to-year percentage growth in wages since the summer of 2009.
With wages rising consistently, consumers are beginning to spend and borrow more. These strong economic trends may continue to lead toward higher price and wage inflation, putting further pressure on interest rates.
What does inflation mean for investors?
No matter what metric you use, it’s clear that we are trending toward higher inflation, and this means it’s time for you to rethink your investment decisions.
In January, CPI exceed expectations with a 0.5 percent increase, and as a result, markets reacted sharply.3 Equity investors panicked, fearing higher inflation and a more aggressive pace of Federal Reserve rate hikes. This left many reassessing the value of their equities and corporate bonds.
What’s important to understand is that you have the ability to hedge against inflation with alternative allocations. Investments in real estate have historically served as a hedge against inflation.4 Unlike equities and bonds, real estate has the potential to capture income from properties as prices rise. Floating-rate corporate credit also has the potential to protect against inflation. These floating-rate coupons react inversely to traditional fixed-coupons as rates rise and pay a variable interest rate that rises as rates do, generating higher potential income for your portfolio.