Life After Full-time Work Blog

What it is; how to offset it; and can it be forecast?

The blurb above tells you exactly what aspects of inflation I’m dealing with in this blog post.

I say that because I’ve written about inflation several times before, none of them with these specific angles in mind, other than actually defining it, of course. [Specifically, posts # 119 (inflation for retirees: is it much the same as for workers?), 120 (the huge inflation we experienced at the time in asset prices, not in consumer goods and services), 121 (how spending changes in retirement, and the resulting need for inflation protection), 158 (if only inflation-protected lifetime income streams were available!), 188 (how inflation would have changed 2022 Personal Funded ratios), 206 (why equities are not an inflation hedge) and 211 (why inflation is different for each of us).]

OK, let’s go!

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Let’s start with a reminder of what it is. In general, inflation means getting bigger, expanding, growing. When it’s applied to prices, it means prices are going up. Nothing new or controversial there.

Measuring it isn’t straightforward. To start with, prices of different goods and services change by different amounts and at different rates. Yet we constantly hear or read in the news that inflation over the last year has been 2.5% (or whatever – I’m just making up the number). What exactly does that mean?

The answer is that every country has identified a specific set of goods and services that are widely consumed, and its inflation measure calculates the average change in the prices of those goods and services over the specified period. In the USA, for example, that “basket” of goods and services id composed of roughly 32% in various forms of housing and shelter, 15% in food and beverages, 9% in medical care, 6% in transportation, and smaller proportions of other things we use.

(From time to time, meaning typically after several years, these proportions are changed, as society’s consumption patterns change. And there are multiple measures of inflation published, for example for the population as a whole, for urban workers, for retirees, and so on. But let’s ignore all those variations and think of just one inflation measure, often called the Consumer Price Index, as the one we’re interested in for this discussion.)

What causes inflation? For the nerds, let’s identify two main types, often called cost-push and demand-pull inflation, and typically both operate at the same time and interact.  Cost-push inflation arises when producers of goods and services raise their prices, typically because they notice that demand at current prices is greater than they can provide, so they can raise their prices and still sell whatever they produce, increasing their profits. Similarly, demand-pull inflation arises when consumers want more of something than is available, and are willing to pay more to ensure that they get it. You can see how both operate together. And (for those who want to dig deeper) inflation is ultimately caused by the fact that the government issues more money, that eventually and indirectly gets into consumers’ hands, and raises demand.

Never mind. That’s just for the nerds. We’re all familiar with inflation, regardless of where it comes from. We have to deal with it.

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How does it affect investment returns?

Well, if we want to consume goods and services today, we’ll do so (assuming we can afford it, of course). Can we be persuaded not to do so, and instead lend some of our money to someone else? Yes – but we obviously want compensation for forgoing current consumption. (Don’t you just love the jargon?!) We wouldn’t say: OK, you can have $1,000 and I’ll cut back on my spending. Or even: here’s $1,000, make sure you return it at some future date. Instead, we’re more inclined to think: Wait, I might be willing to lend you $1,000 (and cut back on my spending) if you promise to repay even more than that $1,000 to me at some future date. For example, repay $1,050 in a year’s time. Aha, now this might start to sound appealing, and we might consider doing it.

That extra $50 for postponing consumption for a year is called “interest,” and in this made-up example it amounts to 5% of the original $1,000 after one year. Obviously there’s no magic in the amount of $1,000 or in the 5% rate of interest or in the one-year time period. It could, for example, be $100,000 over two years with an amount of interest of 21% of the loaned amount. This starts to become very complicated. So, to express it more simply, we wouldn’t say 21% over 2 years; we’d do the calculation (never mind the details) and say: well, that’s equivalent to 10% each year over two years.

(OK, here’s the calculation. 10% over the first year increases the repayment to $110,000 if it’s repaid after a year; and if it isn’t, that’s the same as lending the $110,000 over a second year, and adding 10% to it, which is $11,000, makes the required repayment $121,000 at the end of the second year. That’s’ where the 21% number came from.)

For convenience, regardless of the length of time of the loan, the interest rate can be quoted as an “annualized” rate, that is, what the rate would be if the loan is made for a year: in the example, an annualized rate of 10% per annum.

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What has this lending money got to do with inflation? Well, if we’re going to forgo consumption, we want to make sure that the amount we’re repaid enables us to consume at least the same amount when our loan repaid. So, if inflation is running at 5% per annum, there’s no point simply charging 5% interest on a loan, because the repayment will only replace the forgone consumption, and we won’t have been rewarded at all for forgoing consumption. So it’s logical and reasonable that the interest we charge will be enough to increase the potential consumption when the loan is repaid. And that means that it needs to be higher than the rate of inflation. For example, if we’re willing to forgo some of this year’s consumption provided we can consume 3% more next year, and we anticipate that inflation will be 4% over the next year, we’d charge 3%  + 4% = 7% interest, the 3% as a reward for forgone current consumption and the 4% to make sure that we’re measuring consumption at next year’s prices, because that’s when the deferred consumption will occur.

You don’t need to be able to explain these concepts to anyone. (That’s only necessary when you start to study economics!) You just need to understand them intuitively: if I lend my money to someone, I want an investment return (another jargon expression!) that is equal to anticipated inflation plus a reward for deferred consumption.

And that’s how to interpret any interest rate or investment return that you’re expecting. It’s partly to counteract inflation, and the rest is called the “real” (that is, after inflation). So in my example, the 7% interest rate is a “real” interest rate of 3%.

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Inflation started being measured just before the start of World War 1, but it was a few generations before its relationship to interest rates and investment returns was taken as a natural starting point. It was around 1981 when governments started to issue inflation-linked bonds routinely, and now many countries (in particular, the US, the UK and France) do so. (Two such countries, Germany and Canada, have stopped doing so, with no official explanation as to why they stopped.) Essentially the arithmetic of the bond payments is that the capital amount is increased each year by the preceding year’s inflation, and the “coupon” (the interest rate promised) is based each year on the enhanced amount of the principal. So, for example, an inflation-indexed bond with a stated 2% coupon will pay $2 interest in the first year on every $100 of bonds purchased, and that $2 increases every year by the accumulated inflation since the bond was issued, as does the final $100 capital repayment.

I asked, in the blurb to this post, whether it’s possible for you to offset inflation. And the answer is: yes, by purchasing these inflation-indexed bonds. While the inflation you’re being compensated for is essentially last year’s inflation, over (let’s say) a 20-year period that’s as close as you can get.

Of course, governments bonds aren’t the perfect investment. While you get an inflation-indexed interest payment, typically the “real” amount of that coupon is low (say, 2%), and your return isn’t linked to growth in the economy or even a particular company: that comes from equity investments.

But then equity investments aren’t an inflation hedge. Yes, they’re very often called exactly that, but that totally misleads. An inflation hedge is something that offsets the impact of inflation, even over the short term. Equities don’t do that. They might annihilate the impact of inflation over a short period, or provide a return dramatically below inflation: not exactly a hedge. If you want a hedge, it’s like a boxing match in which you want your fighter to draw each round. Knocking out the other fighter isn’t the solution, particularly when the cost of doing that is to face being knocked out oneself in a fight.

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I also asked: can inflation be forecast? Quite simply, no.

I’ve had people tell me the opposite. Here’s how they see it. Suppose a government issues two sets of 2-year bonds, one with a coupon of 5% and the other with a “real” 2% coupon. The two sets will provide the same return to investors if inflation is the difference between the two coupons, that is, 3% per annum. And so that must surely be the average inflation forecast  over the next 20 years.

Right. It’s the forecast. And it’s an important forecast, because it’s made by people who are willing to put their money where their mouth is. So in that sense it’s the best estimate we can have. Think of it as the breakeven forecast: if it occurs, you neither win nor lose.

But that doesn’t guarantee it’s going to be accurate, or even close to accurate.

In 1978-1981, US inflation was at least 10% in each of those years. That’s why 1981 was the year in which inflation-linked bonds were first issued (by the UK, as it happens). How about more recently, say since 2000? Fortunately, inflation has not been nearly as nasty. Nevertheless, in 2021 and 2022 the US inflation rate was 7.0% and 6.5% respectively: both higher than even the “nominal” coupons on government bonds issued 20 years earlier, so purchasers of the “nominal” bonds didn’t do nearly as well. In fact the coupons on nominal bonds issued 20 years earlier were in the 6% range. And at that time the coupons on TIPS, that is, Treasury Inflation-Protected Securities, or inflation linked bonds, were around 3.75%, so the TIPS holders beat the holders of the nominal bonds.

It doesn’t matter who won or lost. My point is simply that it’s still a bet, with winners and losers, rather than a hedge.

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Takeaway

Inflation means that prices of goods and services are rising. How much depends on how the government’s increasing supply of money affects the demand for and the supply of those goods and services. Occasionally inflation becomes uncomfortably high, for investors, so many national governments now offer bonds on which the annual interest payments and the final capital repayment compensate for inflation since the bond was issued. The difference between the nominal and the real coupons on identical-term bonds issued by any government is the break-even inflation forecast over that period made by investors; but inflation itself may turn out to be higher or lower.

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