Generally, inflation refers to increases in prices or values of goods and services; the most common forms are price inflation and asset inflation.
Asset inflation describes changes in the prices or values of financial assets. These assets could be stocks, bonds, real estate, precious metals and other tangible assets. While important to consider, this is not the type of inflation that we will focus on here.
Price inflation is the more commonly referenced form of inflation and describes changes in the prices of goods and services that are consumed. Most countries prepare data to calculate their local rates of inflation, and the most widely reported measure of inflation is the Consumer Price Index (CPI). The CPI calculates the costs of a defined basket of goods and services at different points in time. The change in the cost of that basket is determined in a specific currency and effectively measures changes in the purchasing power of a unit of the currency (for example, the Canadian dollar, or CAD).
If costs are rising, there is said to be inflation, and the purchasing power of the CAD is declining. This means that your CAD will buy less. Take a cup of coffee as a simple example. If that coffee costs C$2.50 today, but five years ago it was C$2.00, the price has risen (or “inflated”) by 25%, or 4.6% annually. Put another way, five years ago, C$10 would have purchased five cups of coffee but today, would only stretch to four. The purchasing power in this case has declined due to price inflation.
Alternatively, if costs are falling, we are said to be experiencing deflation, which increases purchasing power. Although that may sound favorable to a consumer, there are negative economic and societal impacts that make deflation worse than it might initially seem, so it is something that governments and central banks try to avoid.
There is some controversy surrounding the process for measuring inflation (CPI or other standards) and whether it truly reflects the real-life impacts for all consumers. Every person’s “basket” is different and might not be accurately reflected by the CPI basket. Many people feel that their personal costs are rising more quickly than the published figures. We will leave that debate for another time, but no matter how we calculate inflation, it does exist, and it must be considered as a key parameter when developing a wealth and investment plan.
Inflation is the rate of change in prices or price level and is also used to describe increases in those levels.
Deflation is a decrease in the price level, with a negative rate of inflation.
Disinflation is a decline or slowing down in the rate of inflation. Prices are still increasing, but at a lower rate.
Reflation is used to describe an increase or acceleration in the rate of inflation.
Stagflation is a period in which inflation runs hot but the overall economy is weak, with low or no growth and higher unemployment. This scenario can prove challenging, as high inflation can harm purchasing power, whereas actions taken to slow inflation can make economic conditions worse.
We will elaborate more on purchasing power later, but for now, it is important to realize that a fall in purchasing power can be very harmful for people, as it can impair their ability to maintain their standard of living.
Purchasing power is a measurement of what a unit of currency can buy. Inflation reduces purchasing power, and deflation increases it.
It is often stated that inflation is a monetary phenomenon. This implies that when there is too much money chasing too few goods and services, the prices of those goods and services will rise, causing inflation.
Since the mid-1990s — and compounded subsequently by the global financial crisis and then again by governmental responses to the coronavirus pandemic — there have been substantial increases in the global supply of money. Up until very recently, this has not resulted in any meaningful inflationary pressure. In fact, the coronavirus shutdowns in early 2020 caused declines (deflation) in prices, and only more recently have inflation measures in Canada and the US begun to rise
In addition to the monetary explanation for inflation, which is an oversimplification of a very complex issue, many different factors also impact inflation, making it hard to predict and manage. The primary causes of inflation are generally either “demand-pull” or “cost-push” sources.Demand-pull inflation exists when the demand for goods is greater than the available supply. Take strong economic growth. When the economy is growing, consumers are doing well and choosing to spend more of their newly found wealth. This increases demand for goods and services and likely outstrips supply. In that event, companies risk running out of supply, so they look to increase the prices of their products, which results in inflation. This can also turn out to be an accelerant for additional inflation, because if consumers expect prices to keep rising, they will be incented to buy more now (before prices go up), which exacerbates the issue. A recent example of demand-pull inflation is the coronavirus-related increase in government (fiscal) stimulus. When the government puts more money into people’s hands, more goods and services may be demanded than are available, resulting in an increase in prices
On the other hand, cost-push inflation occurs when there are impacts on the supply of goods and services, which reduces the amount available to meet the current demand and allows suppliers to increase prices for the more limited supply of goods. Examples of this are supply-chain bottlenecks or natural disasters, such as those caused by floods or hurricanes, that reduce the availability of raw materials (for example, oil-rig shutdowns). These bottlenecks impair the industry’s ability to supply goods and services, resulting in suppliers increasing the price for the remaining and now scarce goods.
Interestingly enough, the coronavirus pandemic showed us examples of both demand-pull and cost-push inflation and even instances of both effects applying to the same goods. It is well reported that, as people were locked down at home but still receiving governmental support, which maintained or even enhanced their personal income, they took the opportunity to undertake home renovations. This caused an imbalance in supply and demand, resulting in building-material price increases. Additionally, shutdowns in production facilities (meat-packing plants, industrial factories, sawmills, etc.) caused shortages in their supplied goods such that prices were increased to compensate.
Source: Consumer Price Index (Canada) — all items, Statistics Canada website, September 24, 2021, available at https://www150.statcan.gc.ca/n1/pub/71-607-x/2018016/cpilg-ipcgl-eng.htm.
Inflation is not always positive, nor is it always negative. It is generally believed that some level of moderate inflation is beneficial to the economy and to society. Many global central banks (such as the Bank of Canada, the US Federal Reserve, the Bank of England, etc.) have specific mandates by which they govern their activities. Most of these central banks give consideration to managing inflation, sometimes referred to as price stability, as one of their primary objectives. How they manage this is complicated and beyond the scope of this discussion, but the activities of central bankers in pursuing this objective can have substantial impact on the global capital markets. Whether this recent rise in inflation is temporary (sometimes referred to as “transitory”) or whether it heralds a new economic environment where inflation becomes more prominent remains to be seen.
The Bank of Canada has a mandate to “promote the economic and financial welfare of Canada.” One of its core functions in respect of that mandate is to aim “to keep inflation low, stable and predictable.”
This matters, because if inflation is expected to rise to an unacceptable level, central banks will use their available (and sometimes rather blunt) tools to try to reduce activities in the economy that cause inflation. Typically, central banks consider increasing interest rates. Doing so has far-reaching impacts on financial markets as well as the general economy and business environment, affecting the value of everything: stocks and bonds, governmental budgets, banking, real estate and construction, capital investment, global trade, and many other activities.
See our article entitled Inflation and Disinflation: Debate Rekindled for more information regarding this issue.
It goes back to purchasing power and the need to preserve it. When it comes to investment options, there are many visible risks that can be considered, observed and managed. Unfortunately, a reduction in purchasing power is very much an invisible risk and one that may not be given sufficient consideration. If the stock market goes down, there is a visible impact, as the value of your investment portfolio declines. However, when a portfolio loses purchasing power, there is no readily observable impact. You can actually experience a higher account balance with less purchasing power. So you might not be doing as well as you thought.
Here is a simple way to think about this: If you are not earning an after-tax rate of return that exceeds the rate of inflation, then your portfolio will lose purchasing power.
Are bonds risk-free? Many investors who want to avoid investment risk and preserve capital think investing in bonds is a safe option. They might say that even though the rates of return (yields) are low, a bond is expected to repay their investment at maturity, and they are less likely to lose money compared to investing in the stock market. Unfortunately, that is accurate only with regard to preserving the amount of your capital, but it does not ensure that the value of your capital is preserved. When you consider that the income from a bond is typically taxed at higher rates and yields are low, the after-tax returns may not exceed the rate of inflation, which results in an erosion of your capital’s purchasing power.
Given what we know about the mandates and incentives for governments and central banks, we should assume that there will be inflation in the future. How much, and for how long, cannot be known for certain, but we should not ignore the possibility. We must look to position portfolios to perform well across any of the possible economic scenarios.
Over the past four decades, a well-diversified portfolio of stocks and bonds should have done a good job of keeping up with, and in many cases outpacing, inflation due to the tailwind of declining interest rates, solid equity returns and relatively low rates of inflation. There was also a negative correlation between equities and bonds, which provided portfolio protection in equity market declines. However, during the stagflation economy of the 1970s, stocks and bonds did not perform as well as recent memory and did not keep up with rampant inflation of that period.
Going forward, protection at the same level might not persist and, with much lower interest rates, the cost is higher for potentially less protection. We now need to pay more attention to the impact of inflation on our investment portfolios and ensure that we adequately contemplate inflation risks in addition to the myriad other risks we manage.
Mercer has conducted research regarding how different asset classes perform in the different economic scenarios we may end up experiencing. Although we cannot predict the future with certainty, we can ensure that we are taking steps to protect portfolios and give our clients the best chance of maintaining and increasing the purchasing power of their assets.
The following chart represents the different potential economic scenarios that could occur.
The chart below shows how different asset classes are expected to perform during different economic environments. What seems at first glance to offer protection may only fully protect under specific circumstances, leaving a portfolio exposed if things turn out differently. However, certain assets, such as gold and inflation-linked bonds, that look unappealing in benign growth or inflation environments are well placed to deliver returns when other assets disappoint. These assets are therefore highly valuable from a diversification perspective. And in an era of heightened uncertainty, that diversification potential should be prized even more highly.
Note: These are excerpts from the Mercer article Beware of Inflation — Assessing Risks and Investment Implications.
We have only scratched the surface on the topic of inflation, but if you are looking for more information, please feel free to review the Mercer documents referenced in this newsletter, along with the following articles, which are available on the Mercer website:
Inflation and Disinflation: Debate Rekindled
Beware of Inflation — Assessing Risks and Investment Implications
Inflation Protection — Hope for the Best, but Build Robust Portfolios
Diversified Inflation Strategies, Preparing for Rising Costs of Living
Should you have any questions regarding how Mercer is considering inflation in your Wealth and Financial Action Plan and your investment strategy, please contact a Mercer private wealth counsellor.
For more information regarding inflation in Canada, Statistics Canada maintains a Consumer Price Index portal. This portal includes information describing current and historical rates of inflation in Canada, details regarding the components of the CPI basket and even contains a Personal Inflation Calculator that allows you to calculate an estimate of your personal inflation rate based on your specific expenditures.
The Winnipeg Team