Occam’s – Understanding Inflation
WHAT IS OCCAM’S RAZOR?Occam’s Razor is a principle attributed to William Occam, a 14th century philosopher. He stressed that explanations must not be multiplied beyond what is necessary. Thus, Occam’s Razor is a term used to “shave off” or dismiss superfluous explanations for a given event. This concept is largely ignored within the investment management landscape. This newsletter will “shave off ” popular investment misinformation and present what is important for achieving long-term investment success.
Inflation is one the of the economic topics that you can count on breaking into the public consciousness regularly. It’s hard not to notice that prices go up over time, and now is one of those times that inflation has come to the fore. We’ve had incredibly low levels of inflation for a while now, and that may be changing – though that word “may” is important here.
Why Does Inflation Matter?
It seems simplistic to ask why inflation matters, but it’s an important question to address. So much of the public discussion is basically hyperbole – which is what the financial media is good at. But there’s a lot to discuss here.
To start off with, a certain level of inflation is actually a good thing for the economy as a whole. It greases the wheels and helps to keep things moving along. The “optimal” rate of inflation is something that economists will be arguing about forever, but it’s very likely higher than what we’ve gotten used to over the past decade or so. However, the effects of inflation aren’t spread out evenly.
One of the groups hardest hit by inflation is retirees and, by extension, people preparing for retirement. Which, if you’re reading this, probably includes you. Retirees tend to get hit on both sides by inflation. On the cost side, not only do retirees face the “normal” cost of inflation that people who are working face, but the basket of goods that retirees face is tilted towards things that have historically had higher levels of inflation. The big example of this is healthcare. Retirees tend to spend more on healthcare than other groups, and healthcare inflation is notoriously high.
On the other side, it’s harder for retirees to absorb those higher costs. People who are working are, well, working. They are being paid for that work, and that income tends to, more or less, keep pace with inflation. Overall, retirees are much more exposed to inflation risk than the average investor. But thankfully there are some ways to mitigate this risk. Before we get to that though, let’s look at what we can say about future levels of inflation.
What Will Inflation Look Like From Here?
There are certainly some good reasons to belive that inflation is going to start ticking up. And this is even leaving aside the fact that we have seen higher inflation over the past few months – we care about what happens next, not what has just happened.
We’re still seeing the labor market tighten up as we start coming out of the pandemic – though that’s still a relative term right now. As of June 2021, the unemployment rate is sitting at 5.9%, which is about average over the long term. However, when compared to last April, when unemployment peaked at 14.8%, we’re looking pretty good – especially given that there’s every reason to believe that employment will continue to pick up as the economy continues to open back up. We’re already seeing businesses have to compete to fill their open positions, which is one of the major drivers of inflation.
On top of this, we’ve also had some pretty significant government spending, especially from the various stimulus programs throughout the pandemic. While many of those programs were one-time deals, not all of them are, and even if they won’t all continue indefinitely,they are still pushing money out into the economy now.
But as tidy a story as we can tell for why we should expect rising inflation rates, we actually have another really good tool to predict what inflation will look like going forward – the markets.
Predicting Future Inflation
At their core, the financial market are really complex prediction machines. You have innumerable people, using trillions of dollars, trying to guess what’s going to happen next – and they really care about getting it right. The financial markets are how we collectively harness and collect that information. While I would never say that the markets ever actually get anything “right,” the markets usually provide the best guess that we’ve got based on the currently available information.
And with inflation, we have a really easy way to see what the market expects inflation to look like through time. By looking at the spread between the yields of TIPS (Treasury Inflation Protected Securities – basically treasury bonds that adjust based on inflation) and Treasury bonds of the same maturity, we can see how much people are willing to pay to remove inflation risk. The difference between those two yields is what the market expects inflation to look like over the life of the bond.
We’ll look at the real numbers in a minute, but as an example, if a Treasury bond maturing in 20 years had a yield of 4%, and the 20 year TIPS had a yield of 2%, the market is predicting that inflation will be roughly 2% per year over the next 20 years. We can say this because that’s the differential that investors are willing to pay to get rid of that inflation risk.
While I would be shocked if this estimate ended up being accurate, it’s the best guess that we have given the information that we currently have access to. And that’s crucial. We’re going to get new information – we are constantly getting new information. And that new information is why prices change and markets move. But that doesn’t mean that our current understanding of the situation is wrong, or isn’t useful. It just means that we need to acknowledge the inherent uncertainty, and plan accordingly.
Current Inflation Estimates
So let’s take a look at how the market is currently pricing inflation over different time periods going forward.
|5 Years||10 Years||20 Years||30 Years|
|Treasury Bond Yield||0.87%||1.45%||2.00%||2.06%|
While it’s always a little jarring to see those negative TIPS yields, it just means that in our current investment environment you need to take on some level of risk to keep up with inflation. But that’s more a function of the low interest rate environment rather than expectations of high levels of inflation in the future.
As you can see, based on what investors are currently willing to pay (as of 6/30/21), they are expecting future inflation to be between 2 ¼ and 2 ½ percent, depending on the time frame we’re looking at. While that may be higher than what we’ve had for a little while (though inflation came in at 2.1% in 2016 and 2.4% in 2017), and slightly higher than the Fed’s stated target of 2%, it’s still pretty darn low in the grand scheme of things. From 1948 – 2020, the average annual rate of inflation was 3.5%. But even if we exclude the 70’s and 80’s, and start in 1990, the average annual rate of inflation was 2.4%. In other words, the market is saying that inflation is probably going to be a little bit higher than it has been lately, but pretty well in line with our long term experience. This isn’t likely some doom and gloom hyperinflation situation – or at least the financial markets aren’t expecting that.
What Should You Do About Inflation?
First off, make sure you know where your towel is, and don’t panic. It may be time to bump up the inflation assumptions you’re using in your retirement income plan, but you don’t need to go crazy.
That said, earlier on I did call out that retirees, and people preparing for retirement, tend to be more exposed to inflation risk than the average investor. So let’s talk about a few ways that you might go about mitigating some of your exposure to inflation risk.
The first two ways are actually things that you are probably already doing. Both the stock market and short term bonds provide good (if noisy) protection from inflation risk. They are able to do this because they are constantly incorporating new information about inflation expectations. While this might not help with short term shocks from inflation, they are incredibly important for protecting your portfolio from inflation over the long run. You can think of them providing indirect inflation protection.
But the most direct way of dealing with the risk that inflation poses to your retirement income plan is with TIPS (and I-Bonds – though there are some limits there). We’ve already talked a little bit about TIPS, but these are bonds issued by the Treasury Department that adjust their principal amount based on what inflation does. This has some significant tax consequences (you’re taxed on those adjustments as if they were income in the current year), so you want to pay attention to your asset location, but the money that you have invested in TIPS is pretty much immunized against inflation.
This isn’t magic, though. It’s important to recognize that you are paying for that protection. Aside from diversification, there are (say it with me now) no free lunches in finance. As we’ve talked about, the yield on TIPS is less than the yield on a comparative “normal” Treasury bond by the expected amount of inflation. If the market guessed right, then there isn’t much of a difference between the bonds. But it’s almost certain that inflation will end up being different than what we currently expect – it’s just that we don’t know whether our current expectations are too high or too low.
And this is an important point. If inflation is higher than our current expectations, then you’ll be covered. But if inflation is lower than expected, that will be reflected in the TIPS as well. And it’s basically random whether inflation will be higher or lower than the market’s current estimate. We simply have no way of knowing what the future will hold.
Inflation is a key consideration for people planning for retirement. But it’s important to keep it in context. Despite what we’re all hearing from the financial media, the market seems relatively sanguine about inflation going forward. We’ll probably see more inflation than we have for the past 10 years or so, but not by all that much. It’s important to recognize this and include those expectations in our planning assumptions, but we don’t want to go crazy here. The world, and by extension the financial markets, are constantly changing and evolving. We need to build our long term retirement income plans to be able to deal with those changes.