The Federal Reserve’s new policy framework tolerates higher inflation to create a stronger, more inclusive economic foundation. While the post-pandemic spike may be temporary, many are concerned that continued inflation could become a longer-term problem, reaching higher levels than we’ve experienced in recent decades.
What could drive inflation higher?
Since the COVID-19 pandemic began, authorities have injected trillions of dollars in stimulus into the U.S. economy. Alongside bond purchases by the Fed, the money supply has increased dramatically. Additionally, the Fed has kept interest rates at historic lows.
The personal saving rate soared during the pandemic, largely because there were limited opportunities to spend money amid widespread lockdowns. This created significant pent-up consumer demand. As the economy has reopened, spending and demand have increased, leading to supply chain bottlenecks in areas of the economy where production had previously decreased to match lower demand. In turn, the Consumer Price Index rose by an annualized 5% in May, the largest increase since 2008.
What could keep inflation in check?
At the same time, secular deflationary factors may continue to exert pressure on the Fed’s efforts to feed inflation. Worker productivity has been on the rise for some time, both due to and in line with ongoing technological innovations. The combination of these forces generally means that in many industries fewer workers are needed, which may lead to continued higher unemployment.
Alongside these factors, the increased saving rates of high-income households may help mitigate pent-up consumer demand, as those households spend less of their disposable income than lower- and moderate-income households.
Some inflation can stimulate growth and indicate a healthy economy as people earn and buy more. But too much inflation can create serious economic dislocations, hurting stocks and bonds alike. If the Fed delays reacting to inflation, interest rates may be pushed higher, which can undercut investments.
However, there are a variety of buffers that plan sponsors, consultants and financial advisors may consider to help protect fixed income portfolios from rising inflation. These include: (1) Treasury Inflation-Protected Securities (TIPS); (2) shortening the portfolio’s duration; and (3) increasing exposure to bonds and currencies that are highly correlated to commodity prices. Active managers can adjust exposure to inflationary buffers depending on the current or expected inflation environment.
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