Inflation has been under the radar for the last several years, hovering well below historical averages. This backdrop boosted stocks, longer-maturity U.S. Treasuries and other assets that benefit from low inflation.
Nevertheless, several factors suggest higher inflation may be on the horizon, which underscores the importance of hedging a portfolio’s inflation risk. Treasury Inflation-Protected Securities (TIPS) are one way to do that.
Inflation Faces Pressure on Three Fronts
We believe three key factors—the Federal Reserve (Fed), the federal government and COVID-19—ultimately will drive inflation higher.
1. Two key components of current Fed policy—ultra-low interest rates and quantitative easing (QE)—likely will lead to higher inflation over time due to the increased amount of money in the economy.
In addition, the Fed recently replaced its 2% inflation target with a flexible approach aimed at achieving an average inflation rate of 2%. This means the Fed will allow inflation to run modestly higher than 2% to make up for periods of low inflation.
2. Fiscal policy, including massive federal government spending and deficits, may eventually push inflation higher. And if the Biden administration embarks on a re-regulation campaign, it could also lead to a broad range of price hikes.
3. Fallout from the pandemic may have inflationary implications. Specifically, a backlash against globalization could prompt the federal government to take steps to encourage domestic production of strategic goods, which could drive prices higher.
While the rollout of COVID-19 vaccines should bring a return to normal life—and normal spending patterns—supply and demand imbalances due to the pandemic could trigger higher prices. From a broader perspective, the combination of a weaker U.S. dollar and improving global growth stemming from pent-up demand likely will lift goods prices.
Even Low Inflation Can Do Long-Term Damage
On the surface, the Fed’s goal of a 2% (or slightly higher) rate of inflation seems relatively low. However, even small increases in the average inflation rate can diminish a portfolio’s purchasing power over time.
Consider this: Over the last 25 years, inflation has averaged 2.14%.* But that relatively modest rate has translated to a significant loss of purchasing power. For example, at that rate of inflation, an item that cost $100 in 1996 would cost approximately $165 today.
How can investors position their assets to avoid lasting damage from inflation? An allocation to TIPS may help.
TIPS Seek to Preserve Your Purchasing Power
TIPS are a class of U.S. Treasury securities designed to help protect investors from the long-term, corrosive effects of inflation. Unlike nominal Treasuries, the face value of TIPS changes along with the inflation rate. As inflation rises, the principal value of the security increases, creating a steadily growing stream of interest payments.