Don't be surprised by inflation

While many economists are predicting a year-over-year increase in inflation, the consensus is that long-term inflation will remain subdued and will not continuously exceed the 2% long-term target. However, markets may be underestimating the potential for surprise inflation and upside risks to long-term sustained inflation arising from a faster-than-expected economic recovery and other structural changes.

Recent retail sales figures are already signaling a surprise uptick in inflation as they significantly beat expectations and are now above pre-COVID-19 trends. Additionally, a fierce debate is happening among economists and policy makers about the inflationary impact of President Biden’s $1.9 trillion pandemic rescue plan.

Larry Summers, Treasury Secretary under former President Clinton and senior economic advisor to former President Obama, argues that the $1.9 trillion proposed stimulus is much larger than the 2021 projected output of $420bn. This, combined with another $3 trillion of stimulus from 2020 and record high levels of household savings, may overheat the economy and lead to much higher inflation than anticipated.

Furthermore, the US Federal Reserve’s recent policy shift to average inflation targeting may be a key contributor to long-term inflation. As Nobel-winning economist Thomas Sargen highlighted in his 1982 paper The Ends of Four Big Inflations, previous periods of sustained long-term inflation have been fueled by record levels of debt-financed deficit spending and central banks’ willingness to allow inflation to run.

 According to the Institute of International Finance, global governments borrowed $19.5 trillion in 2020 to finance COVID-19 recovery efforts. The increase in production costs from disruption in supply chains and de-globalization may also contribute to long term structural changes and inflationary pressures.

Governments around the world are pressuring companies to relocate the production of strategic goods (masks, medicine, computer chips) to their home countries, which will increase labour costs and overall prices. The disruption of the trio of “tech, trade and titans” which have driven disinflationary trends over the past 30 years via cheap imports, technological advances and low labor costs could also drastically change long-term inflation dynamics.

These factors, combined with constraints on central banks to raise interest rates in an environment of rising and elevated debt, could raise doubts about the credibility of inflation targets and the ability of central banks to anchor inflation expectations. Inflation is a lagging indicator, so it’s important that investors are not caught off guard by underestimating the potential for longer-term inflation. They should build in inflation hedges in their portfolios for a post-COVID-19 world.

Long-term inflation may also significantly impact investors’ ability to meet their future cashflow and retirement needs, which is why pension managers typically index their liabilities to inflation. Individual investors would be wise to follow a similar approach and build an insurance policy against actual and expected inflation.

Treasury inflation-protected securities (TIPS) are a great tool to hedge this risk. TIPS are US government Treasury bonds indexed to inflation to protect investors from a potential decrease in their money’s purchasing power. They provide diversification benefits due to lower volatility and greater price stability compared to nominal (conventional) bonds. You can read more about them here.

Find out more about how to use Mackenzie US TIPS Index ETF (the first Canadian-domiciled TIPS ETF) to help insure against inflation. For advisors, speak with your Mackenzie sales team; for investors, talk to your financial advisor.