In light of all stimulus packages being pumped into the U.S. economy in response to the shock from COVID-19, some investors are becoming nervous about inflationary pressures.
As a result, inflation has been thrust to the forefront of the economic discussion in recent weeks. For the most part, economists define inflation as a rise in the general level of prices over a specified period and typically use the Consumer Price Index for All Urban Consumers (CPI-U) as a point of reference for tracking the inflation rate.
For instance, the Bureau of Labor Statistics (BLS) reports that, before seasonal adjustment, the CPI-U increased by 1.7 percent over the 12-month period ending in February. The online inflation calculator provided by the BLS shows that $100 in February of 2020 would elicit the same buying power as $101.68 this past February.
Since inflation reduces the per-unit purchasing power of money, this translates to a 1.68 percent erosion in the value of cash on a year-over-year basis.
The Federal Reserve, which monitors risks to the financial system, expects inflation to reach 2.4 percent in 2021. This inflation estimate is above the Fed's official target of 2%, but policy-makers expect the rate to fall back to around 2% in 2022.
Some Fed watchers and market pundits are expecting higher rates of inflation in the coming years, owing to the fiscal and monetary policies set in place to shore up consumer demand.
The reason is that printing so much money to boost the economy could cause a spike in prices if the money supply grows faster than the actual growth in real economic output. In other words, when more dollars are made available in the financial system to chase after a limited number of goods and services, prices are likely to go up - a condition that economists refer to as Demand-Pull Inflation.
As a result, news reports warning about rising inflation have swamped the financial media, thereby heightening the asset price volatility of both stocks and bonds. Analysts worry that once inflation fears begin to pick up, they are difficult to control.
If inflation rises too much above the 2% target, the Fed will likely implement a contractionary monetary policy to try to keep it contained.
While it is unclear which types of news investors generally rely on to form their expectations about inflation, if you are retired or getting close to retirement, then it is probably a good idea to allocate a portion of your portfolio to inflation-sheltered securities.
Conventional wisdom suggests that retirees can hedge inflation risk using Commodities, Series I Bonds (the "I" denoting inflation), and Treasury Inflation-Protected Securities (TIPS).
The CPI-U is partly based on commodity prices, so inflation and commodity prices tend to move in the same direction. As a result, commodities have a consistent record of being a good inflation hedge.
Given the prevailing low interest rate environment, prospective retirees seeking higher yields or those with a higher tolerance for risk may favor commodity-based inflation hedging compared to bond-based hedges using either I Bonds or TIPS.
However, retired and risk-averse investors approaching retirement should probably consider I Bonds and TIPS despite their historically low interest rates. These types of bonds are structured to offer investors a fixed return plus some degree of inflation protection.
While retirees will not receive a drastic payoff in terms of real returns, at least the purchasing power of their money will be protected in an investment period characterized by higher expected inflation.