Ronald Reagan once said, “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.” But what do we actually mean by inflation? By the same token, how confident are you of defining deflation, disinflation and hyperinflation?
Reagan was elected US president in 1980. At the time, the price of a gallon of unleaded gas was about $1.13. By the end of May 2022, the same commodity costs $4.61—an increase of 308% (Figure 1).
Figure 1. The cost of 1 gallon of unleaded gasoline. Source: EIA
Over the same 42-year period, the US Consumer Price Index (CPI), which measures the general level of prices, has increased from a value of 78 to 282, representing an increase of 262%. In some respects, gasoline has been adversely impacted; but the CPI covers a basket of commodities—each with a different weight. Indeed, as this piece is being written, the level of US inflation has hit a 40-year high, with the June CPI reaching 9.1% per annum (Figure 2).
Figure 2. The annual percentage change in prices as recorded by the consumer price index. Source: Federal Reserve St. Louis
Using the CPI as our measure, the average annual rate of inflation over the 42 years since Reagan was elected has been about 3.11%. For many people, this is often dismissed as an irrelevance as it is “just a small number” and nowhere near the 14% witnessed in June 1980. But this misses the point about the cumulative impact on an investor’s purchasing power. With that average level of inflation, $100 in 2022 would buy you 72% fewer goods and services than the same amount of money in 1980.
This brings us to the most important inflation mantra: investors should care about goods and services that money can buy, not money itself.
You may feel rich if you owned a 100 trillion dollar note, but not if it only buys a loaf of bread.
The issue of inflation is of greatest concern to investors holding interest-generating instruments, such as fixed coupon US Treasury bonds. Here, the issue of a loss of purchasing power becomes very relevant. The investor receives a fixed cash flow semi-annually, whose purchasing power will decline when there is inflation.
One of the most useful relationships within an inflation framework is the Fisher equation. In its original form it states:
Nominal yields (n) = real yields (r) + expected inflation (f) + risk premium (p - for unexpected inflation).
More formally, it is written as:
(1+n) = (1+r) (1+f) (1+p)
Over the years, the risk premium and expected inflation components were often shunted together and expressed as a single factor and loosely termed “breakeven inflation.” This is often widely interpreted as a measure of inflation expectations. However, this definition is not strictly correct and is a topic that we will address in our "Inflation and Actions to Take for Your Portfolio" webinar.
Note that the breakeven is an implied value. It is possible to observe nominal yields (e.g., from non-inflation-linked bonds) and real yields (from inflation-linked bonds). So the difference between the two is the breakeven.
It is more accurately referred to as the breakeven spread. Rather than being the market’s expectations of future inflation, we will illustrate that it represents the level of future-realized inflation that would make an investor indifferent between holding a nominal bond or an inflation-linked bond.
Inflation is a topic that, for many years, practitioners dismissed as irrelevant as it was “just a small number.” Big or small, everyone needs to understand inflation in order to avoid being mugged.
Join the SS&C Learning Institute on August 16, 2022, for our "Inflation and Actions to Take for Your Portfolio" webinar. As the Federal Reserve raises rates to combat rising inflation, industry expert Neil Schofield will discuss two main topics in this webinar. First, what is meant by inflation and the associated concept of real and nominal frameworks, and second, an explanation of the mechanics of inflation-linked bonds.
The SS&C Learning Institute is a division of SS&C dedicated to providing continuing education for today’s professionals. Our webinar offerings are delivered by industry-leading subject matter experts and cover a wide variety of topics, from key regulatory updates and new investment vehicles to trending topics such as ESG investing and digital assets. To learn more about the SS&C Learning Institute, please visit ssctech.com/learn.
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