Download Investment Basics: Inflation – Its Causes and Impacts

INSTITUTIONAL INVESTMENT & FIDUCIARY SERVICES:
Investment Basics: Inflation – Its Causes and Impacts
By Joseph N. Stevens, CFA
Area Assistant Vice President
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Anyone driving a vehicle for some period in the past decade likely has
personally experienced the painful increase of prices at the gas pump. For
the 10 year period from 2004 – 2013, the average price of unleaded gas in the
United States increased 221% from $1.59 to $3.53, based on data from the
U.S. Department of Labor. A price increase such as this is referred to as
inflation, a phenomenon that has occurred at different times throughout
history, from the hyperinflationary period in Germany in the 1920s to the
United States in the 1970s. While the topic of inflation garners much
attention from the media and general public, what exactly are some of the
causes of inflation, and what is its impact on the economy and financial
assets?
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Causes
One cause of inflation is imbalances between the supply and demand for
certain products. Changes in the price of unleaded fuel, for instance, are
closely related to changes in the worldwide supply and demand for crude oil,
since unleaded fuel is a byproduct of crude oil. Higher gas prices can occur
from factors that increase demand for oil, such as population growth or from
supply shocks that limit oil production or transmission – such as instability in
the Middle East or hurricanes in the Gulf of Mexico. Alternatively, oil prices
can be held in check by rising supplies, such as those resulting from the
increased use of hydraulic fracturing techniques that enhance the output of
oil wells. A particularly troublesome aspect of inflation caused by productspecific demand and supply shocks is that it can be spread, as in the example
of companies passing increased energy costs on to their customers by raising
prices of their own products or services.
Another common cause of inflation is currency depreciation, which occurs
when one currency becomes less valuable in terms of another. For example,
if the dollar depreciates relative to the Japanese Yen, more dollars are
required to acquire the same product in Yen.
Another common
cause of inflation is
currency
depreciation, which
occurs when one
currency becomes
less valuable in
terms of another.
A company that utilizes foreign markets as part of its supply change is
affected by this exchange, which may lead the company to pass on some, if
not all, of the higher costs to its customers.
In some cases an increase in the money supply itself can lead to inflation, a
theory supported by Nobel Prize-winning economist Milton Freidman, who
illustrated this point with a hypothetical story in which a helicopter drops
money onto an island. In this example, the increase in the money supply
would lead to more money chasing the same amount of goods, thus driving
up the prices of those goods. The theory, importantly, relies on two
assumptions: that people’s willingness to hold money is constant, and that
the economy is operating at full capacity. In practice, the amount of money
people wish to hold and the strength of the economy vary significantly, and
thus an increase in the money supply may not always be inflationary.
Accordingly, an increase in the money supply is more likely to be
inflationary when the economy is operating at full employment and capacity
and people are ready to hold less money.
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Impacts
Higher rates of inflation can be particularly damaging to investment assets
that generate fixed cash flows, such as bonds, since the amount of cash flow
does not increase despite rising prices elsewhere. The value of financial
assets can also be affected by inflation because of how assets are valued. For
instance, a common technique used to value an asset is to discount the asset’s
projected future cash flows at an interest rate that compensates an investor
for liquidity, credit, interest rate and inflation risk. All things equal, as
investors’ expectations for inflation increase they require higher interest rates
to compensate them for the additional risk; as such, discounting an asset’s
future cash flows at a higher interest rate results in a lower price for that
asset. Asset prices can also be affected if cash flows are reduced by
inflation, such as the case when businesses face higher costs for raw
materials. If that business is unable to pass along those higher costs to its
customers, it will experience lower earnings and thus be less valuable of a
business. On the other hand, higher inflation generally will be less damaging
to investments where the cash flows vary with inflation or where the price of
the asset itself increases along with inflation, such as commodities,
infrastructure or real estate.
Inflation not only impacts Wall Street, but can create inefficiencies on Main
Street. For instance, “menu costs” refers to the cost firms incur when they
continually adjust their products or offerings to account for inflation. This
can create an environment of unstable prices, which makes it difficult for
customers to efficiently allocate their resources to purchases goods and
services, causing detriments to the economy. It also negatively impacts
business profits, as organizations often incur costs to continually
communicate their price changes. An extreme example of this occurred
during the hyperinflationary period of the 1920’s in Germany when it was
common for waitresses to stand on tables several times during lunch and
shout out new prices.
Another significant inefficiency associated with inflation occurs when it is
unexpected. If inflation is expected, creditors can increase the interest rate
they require to compensate for decreases in future purchasing power.
However, when it is unexpected, wealth is redistributed from creditors to
debtors as debtors pay back loans with less valuable dollars. If there is
considerable uncertainty surrounding inflation, creditors will require higher
rates and make fewer loans, which will result in lower real economic growth.
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Conclusion
For twenty years from 1993 – 2013, inflation represented by the Consumer
Price Index (“CPI”) in the United States has rose at a rate of 2.4% per year.
As a U.S.-based investor, it’s easy to be complacent regarding inflation
because it has been benign for so long. However, during the 10 year period
from 1972 – 1981 the CPI rose at an annualized rate of 8.6%. As described
in this paper, there are a number of factors that can trigger inflation, although
forecasting these factors is difficult. Although we may not be able to predict
when conditions conducive to inflation will occur, we can say with
reasonable certainty that they will. Despite the potential risks and difficulty
forecasting inflation, there are still actions investors can take to protect
themselves. Investors should ensure their portfolios are hedged against
inflation risk by owning assets whose value is expected to vary with
inflation, such as commodities and real estate.
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Although we may
not be able to
predict when
conditions
conducive to
inflation will occur,
we can say with
reasonable
certainty that
they will.
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About the Team
Joseph N. Stevens, Area Assistant Vice President, is part of the Institutional
Investment & Fiduciary Services team of Arthur J. Gallagher & Co.,
Gallagher Fiduciary Advisors, LLC (“Gallagher”), focused on improving the
investment program of your benefit plan and other investment pools.
Gallagher’s Institutional Investment & Fiduciary Services team are a group
of established, proven investment professionals who provide objective
insights, analysis and oversight on asset allocation, investment managers, and
investment risks, along with fiduciary responsibility for investment decisions
as an independent fiduciary or outsourced CIO.
Joseph N. Stevens, CFA
Area Assistant Vice President
Institutional Investment & Fiduciary Services
[email protected]
202.898.2270
www.ajg.com
© 2014 Gallagher Fiduciary Advisors, LLC
Investment advisory services and named and independent fiduciary services are
offered through Gallagher Fiduciary Advisors, LLC, an SEC Registered Investment
Adviser. Gallagher Fiduciary Advisors, LLC is a single-member, limited-liability
company, with Gallagher Benefit Services, Inc. as its single member. Neither
Arthur J. Gallagher & Co., Gallagher Fiduciary Advisors, LLC nor their affiliates
provide accounting, legal or tax advice.
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