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Last month, Gallup reported that 7% of Americans consider inflation to be the country’s biggest problem, which ties the highest percentage polled since 1986. According to a University of Michigan survey released this month, Americans expect that prices will rise at an annual rate of roughly 5% over the next twelve months. That matches the highest level of expected inflation in thirteen years. 

So there’s a lot of inflation-induced anxiety at the moment, and understandably so. If prices rise but income does not, it’s realistic to assume that standards of living will suffer for many. But how does purchasing power relate to inflation? More to the point, how can we invest to protect our standard of living during inflationary times?

CPI

A little background: each month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track price fluctuations. It’s developed from detailed expenditure information provided by Americans on purchases they made in categories like food and beverages, housing, apparel, transportation, medical care and recreation.

Over time, the CPI’s calculation has changed, most significantly to smooth out “volatile” movements in food and energy costs as well as to account for substitutions consumers make when prices for some items rise relative to others. (Hamburger meat for steak is a classic substitution.) For the 20-year period ended 2020, the CPI bounced around an historical average of 2.1%. But in 2021 inflation broke out of its range. As of November, the CPI rose to 6.8%, the highest in nearly four decades. 

The markets were duly shocked, but there’s an element of abstraction to the CPI that can blunt its power over Wall Street. Over Main Street, not so much. Many of us wonder, “If the current annual inflation rate is only 1.4 percent, why do my bills seem like they're 10 percent higher than last year?” Clearly, the cost of a number of important things, like healthcare, housing and education, have been rising a lot faster than the CPI suggests. In other words, our guts have been telling us that inflation is nothing new. This disconnect underscores the importance of understanding how inflation is reported and how it can affect our investments.

Inflationary Effects

As inflation rises and falls, three notable effects ripple through the asset markets. First, inflation reduces the real rate of return on investments. For example, if an investment earned six percent for a 12-month period, and inflation averaged 1.5 percent over that time, the investment’s real rate of return would have been 4.5 percent. If taxes are considered, the real rate of return may be reduced even further.⁴ 

Second, inflation puts purchasing power at risk. When prices rise, a fixed amount of money has the power to purchase fewer and fewer goods. It’s important to ask yourself whether an investment that is nominally profitable is still wise if and when its yield falls below the CPI.

Third, inflation influences the actions of the Federal Reserve. Its toolbox includes both fiscal and monetary methods for reducing the amount of money in circulation. Hypothetically, a smaller supply of money would lead to less spending, which may lead to lower prices and lower inflation. And even the expectation of the Fed injecting more money into the economy, or removing money from the economy--so-called “tapering”--can affect asset prices, by a lot.
 

A Few "TIPS"

None of us can predict what the Fed will do. Neither can we know where inflation will be months or years from now, but we still have to make investment decisions in the present. Thankfully, there are some dynamic investments that take into account future inflation. The most popular of these are Treasury Inflation-Protected Securities, or “TIPS.” Unlike conventional U.S. Treasury bonds, the principal amount of TIPs is adjusted with changes in the CPI. When the CPI increases, for example, a TIPS’s principal increases. If the CPI falls, the principal is reduced.

Also, the relationship between TIPS and the CPI can affect their bi-annual interest payments as well as the amount paid at maturity.² TIPS pay a fixed rate of interest, but because the fixed rate is applied to an adjusted principal, interest payments can vary from one period to the next. TIPS help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the CPI— while providing a real rate of return guaranteed by the U.S. Government.

One last thing: when TIPS mature, the bondholder will receive either the adjusted principal or the original principal, whichever is greater. If you are concerned about inflation – and expect short-term interest rates may increase – TIPS are worth considering. A close review of your overall strategy might also reveal other investment choices that may be appropriate in an environment of changing interest rates.

The investments you make will necessarily reflect your own perspective, though their success may be a function of the overall market’s psychology, at least in the short-term. As The Wall Street Journal reported this month, inflation can enter a vicious cycle whereby “workers demand higher wages, which drives up prices, leading workers to expect rising inflation and continued increases in wages, and so on.” Which sounds scary, but there is a silver lining. Short-term anxiety returns to normal over the long haul. For example, the Federal Reserve Bank of Philadelphia reports expected inflation at 2.9% a year over the next five years, and just 2.55% over 10 years.

Of course, expectations can change and inflation doesn’t affect everyone equally. Price increases tend to harm those on the lower end of the economic spectrum far more than those at the top. For this reason, President George H.W. Bush famously called it “the cruelest tax.” This inequity might explain why Google failed to elicit much pushback this month when it refused to adjust its employees wages to inflation, while workers at Kellogg and John Deere both went on strike this year, in large part to demand higher wage increases. Fear of inflation is also one of the reasons a Starbucks store unionized for the first time ever this year, and more may be coming.

But remember that just as important as purchasing power, is earning power. Given both The Great Resignation and the rolling retirement of 72 million Baby Boomers, earning power increasingly means passive earnings, aka investment income.

You don’t need a crystal ball to invest well, though your expectations of both purchasing power and earning power should be aligned correctly. There may be more to fear than fear itself these days, but panic won’t help. With the specter of inflation hanging over your portfolio like the sword of Damocles, don’t freeze. Plan ahead.