How to Fight Inflation

One of the guiding principles of the finance world for decades has been that a little inflation is good, but a lot of inflation is something that governments and the Federal Reserve need to fight against. However, that narrative has shifted somewhat, as the U.S. Federal Reserve and central banks have softened inflation targets, and instead focused on full employment as their primary economic target. The Federal Reserve now recommends that inflation targets around 2% on average, which allows some years to drift above the long-term trend. In addition, the Federal Reserve has become reactionary rather than preventative when inflation changes, which means less time to make rapid adjustments. Many of these policy changes have been developing across political administrations and across multiple Federal Reserve board chairmen/chairwomen.

Many of the policy changes I just mentioned are now interacting with a post-Covid economic world, where additional stimulus funds and unemployment have created surplus spending for some American households. Spending drives demand, and increased demand drives inflation. Inflation is a measure of the rate of rising prices of goods and services in an economy. It tends to increase during periods of economic expansion, where high demand allows businesses to charge higher prices as consumers are willing to pay more for a product. Inflation is measured by the Consumer Price Index (CPI), which is a weighted average “basket” of consumer goods, such as food, medical care, and transportation. CPI also includes measures of energy and housing costs.

In April 2021, inflation (CPI) rose by a staggering 4.2% from April 2020, driven by the economic recovery of the U.S. as states relax Covid restrictions, and business activity increases. From a financial planning perspective, protecting against inflation is crucial. If you need your assets to supplement your income from the ages of 65-95, but you’re just holding cash or safer assets (e.g., government bonds, CD’s, Money Market funds), you are potentially losing money each year to inflation. That means your purchasing power declines over time, and you may experience a funding shortfall in retirement.

How do you combat inflation in your portfolio?

Increase your stock allocation. To protect your purchasing power in retirement, you need assets that will outpace inflation. For better or worse, holding stock is always the best way to protect your purchasing power. Since 1926 at its inception, the S&P 500 index has returned around 10% annual gains to its holders, or about 7% after inflation. Shareholders of major companies have historically been rewarded with generous capital gains that can easily handle price increases in consumer goods over time.

Take more risk. To adequately fight inflation (especially in a low interest rate environment like today) means venturing into more aggressive investment options. That might be stock (see above), TIPS, or gold (see below), but in all three situations those assets are more volatile than holding cash or short-term bonds.

Treasury Inflation Protected Securities (TIPS). Many Arrow portfolios have allocations in this asset, as we believe its an excellent way to fight inflation. TIPS are a great source of inflation protection as they are short-term government bonds, with payments that are directly tied to consumer prices. In other words, if inflation increases, your interest payment increases. TIPS are never going to outpace stock in a growing market, but they will provide better protection than normal short-term bonds in a high inflation environment.

Consider gold and commodities. Historically, gold has performed well in high inflation environments. However, gold tends to underperform other assets like stock, and it produces no income (dividends, interest) like many other assets. So, it might be beneficial to temporarily increase a gold allocation, but long-term your portfolio might suffer.

Similarly, commodities like copper, oil, grain, beef, precious metals tend to increase in price dramatically during inflationary periods, but also tend to underperform stock over the long run. So temporarily commodity positions might be beneficial, but the timing needs to be done exactly right to capture the rise in prices. Moreover, directly purchasing commodities can be complex, and involves margin-based futures contracts that can be daunting for many investors.