Managing Inflation Expectations

Steve Saville At TSI we rarely talk about what central banks are doing with their gold. This is because historical data and our own observations tell us that when the financial-market and economic trends are positive for gold the gold price will trend higher regardless how much gold the central banks sell or threaten to sell. We therefore try to stay focused on 'the signal' (trends in currencies, interest rates, asset prices) and ignore 'the noise' (central bank jawboning about gold, the Washington Agreement, reports of central bank gold sales/purchases, etc.). This is not to say that governments and their central banks don't attempt to influence the gold price, because they most certainly do. However, it is clear from what happened during the 1970s and what has happened over the past few years that the inter-market relationships and other factors that SHOULD drive the gold price WILL drive the gold price regardless of the amount of direct intervention in the gold market by governments and/or their agents. The reason this is so is that confidence in the official currency will start to diminish and the investment demand for gold bullion will consequently start to rise once the effects of the central bank's inflation policies become evident outside the realm of financial assets. And once the process of inflation recognition is set in motion any attempts to suppress the gold price via central bank gold sales will only make matters worse (for the central banks) by further reducing confidence in the currency and boosting the investment demand for gold. It is also worth noting that the total amount of gold bullion held in central bank coffers is miniscule compared to the total amount of fiat currency in the world and for this reason alone the idea that central banks can somehow control the gold price by drip-feeding their gold onto the market, either via sales or loans, is absurd. In a gold bull market the psychological effect of central bank gold sales is also not significant beyond the very short-term and in fact might, for the reason mentioned in the above paragraph, be the opposite of what many people first think. What governments and central banks have learned, perhaps as a result of what happened during the 1970s, is how to influence the gold market INDIRECTLY. Actually, central banks don't care what the gold price is; what they care about are inflation expectations. The gold price, in turn, is just a reflection of the prevailing level of inflation expectations, meaning that if central bankers and politicians do a good job of managing expectations then the gold price will take care of itself. So, how are inflation expectations 'managed'? The below chart provides one example. The red line on the chart indicates the yearover-year change in the CPI and also highlights the great 'progress' made by the US Government over the past 20 years in the field of expectations management.

To further explain, compare the performance of the 'red line' during 1971-1983 with its performance since 1992. Now, if this were the only information you had to go on you would probably come to the conclusion that 1992-2004 was a period of great price stability in both absolute and relative terms; yet during this period we have seen: a) The money supply growth rate rise from around zero during the first half of the 1990s to near the peak levels of the 1970s by 2001 b) One of the greatest stock market manias of all time followed by one of the greatest stock market collapses of all time c) Many commodity prices go from multi-decade lows during 1998-2001 to multi-decade highs by 2004 d) Spectacular gains in the prices of housing, insurance, education, healthcare and energy e) A 50% rise followed by a 30% fall in the Dollar Index And through it all we have seen the CPI oscillate mildly at a low level.

Making sure the CPI remains low and non-volatile is just one aspect of the expectations management that occurs on a daily basis. Other aspects are more subtle and involve the planting of ideas, such as the deflation smokescreen that has prevented many 'experts' from believing the evidence of their own eyes. If you really want to understand how central banks and governments manipulate markets then don't waste any time thinking about gold sales/loans, or the so-called Plunge Protection Team, or what the Exchange Stabilisation Fund (ESF) may or may

not be doing with the relatively small amount of money it has at its disposal. Instead, think about how central banks are able to inflate like crazy while much of the world agonises over the threat of deflation.

The Basics of Managing Inflation Risk

What is inflation?

Inflation refers to an increase in the average price level in the economy. One way economists measure inflation is by tracking the price of an average basket of goods in the economy. The most common inflation index is the Consumer Price Index. Its important to remember that inflation is an average. Some goods, notably electronics, decrease in price even when there is inflation. What is the risk? A dollar just doesnt go as far any more Inflation means a dollar buys fewer goods than before. This is not necessary a problem since inflation can affect salaries and expenditures at the same time. If you were given a 5% raise and inflation was 5%, then you could still buy the same goods on average. Employers typically account for inflation when giving raises. The things most vulnerable to inflation are stated in fixed dollar amounts. These dont get adjusted and inflation erodes their purchasing power. Some examples are:

Cash of all kinds o paper money, checking accounts, savings accounts Fixed income o bonds, social security, pensionsthough adjustments like cost-of-livingallowances may reduce the pain Money you lend out o $1,000 your friend returns to you ten years later

There is one more cost to inflation. Because prices rise, companies have to update their listings in brochures, menus, and other materials. These costs are aptly named menu costs. Are there any good aspects? In theory, inflation helps borrowers with fixed interest or fixed dollar amount loans. If you have to repay a fixed amount of money, then inflation reduces the real value of the debt. This benefit is not always realized because financial institutions compensate. As pointed out on Advanced Personal Finance, first time home buyers can get priced out of the market with absurdly high interest rates. How can I manage inflation risk? There are three typical ways to deal with inflation risk.

Spend money now

Its not often we American money writers can encourage spending, but this is one such case. Money you spend now avoids inflation risk. Unfortunately, this strategy encounters several other risks if you overspend. But it is a time when spending money now is better, and it serves as a reminder to super-savers that money later is not always better than money now.

Buy investments with higher returns (like stocks)

I try to warn people that FDIC-guaranteed deposits are not risk-free. Money kept in cash or lowinterest checking and savings accounts is virtually guaranteed to lose purchasing power. An example: money in a no-interest checking account almost loses a whopping 25 percent of its purchasing power over 10 years, assuming a moderate 3 percent inflation rate. Even high interest rate savings accounts like ING Direct are unlikely to beat inflation when taxes are considered. To increase purchasing power and outperform inflation, its necessary to invest in higher return options, like stocks. While these investments have own risks (all the money can be lost), there ways to manage them through some long-term strategies like having a well-diversified portfolio. More on that in another article. To summarize: inflation risk makes it necessary to find higher return investments like stocks.

Consider Treasury Inflation-Protected Securities (TIPS)

It is possible to get a guarantee on principal and keep up with inflation. The U.S. government has created bonds with returns indexed to inflation. Some worry that TIPS have had too low rates, even after considering the inflation adjustment. But some advisers, like Scott Burns at AssetBuilder, suggest TIPS can be an important part of a well-balanced portfolio. Ive read the inflation-adjustment raises some important tax considerations, so do your work before investing. Side Topic: Why cant the government make inflation zero? I want to preempt an often asked question: why does inflation exist at all? This is a controversial question, so Ill just stick to the basics from my economics training. There are two main reasons why some inflation is okay. The first reason is that inflation is better than deflation, which means prices would be scaled back. Why is this bad? Deflation means that all debtors have larger obligations. This would increase the rates of defaults and could lead to a big credit crisis. Companies go bankrupt, workers get laid off, and loans are hard to come by. This is what happened during the Great Depression, Americas worst economic contraction.

The second reason is that inflation can occur when pursuing other desirable policies, like having a high employment rate. There are two processes called cost-push inflation and demand-pull inflation that explain the phenomenon. Ultimately, I dont worry too much about these policy matters as I have little impact on inflation. I focus on being prepared practically, which means choosing good investments.

Imperatives of managing inflation Posted on June 9, 2010 | Author: G N Bajpai | View 348 | Comment : 10

If the menace of inflation is not dealt with severely, it has the potential to paralyse the growth of our economy and dampen the spirits of the poor and middle class, who have been the bedrock of economic growth.

The threat of inflation to the growth of Indian economy and comfort of society is real and serious. Those who are in touch with the common man, both in urban and rural areas, can decipher their pain. Top-line inflation or wholesale price index (WPI) was up at 9.6% in April 2010. The index for primary articles for the week ended May 22, 2010, was up 16.89%, year-on-year (yoy). The consumer price index (CPI) for industrial workers was at 13.33% in April 2010 and that for agricultural labour as well as rural labour at 14.96%. Initially, the price rise was very steep for food articles only. This has since spread to manufactured items such as textiles, steel and cement. As long as nonfood inflation was below 5%, policymakers were comfortable. Now, with inflation spreading to the manufactured sector it has emerged as the biggest worry'.

Inflation is considered to be the harshest taxes that a state can (unwittingly) levy on the poor. It builds/heightens social disquiet among the masses, and can even derail the political stability and order of society. Governments have been voted out for the sudden and disproportionate rise in prices of onions and potatoes. However, it is intriguing to find that the usual manifestations of unease with high inflation, including the enthusiasm on cut motion, have been rather subdued. The civil society activists, who are substantially supported by the media, sometimes even on non-issues, are apparently focused somewhere else. The media finds reporting on the controversy over the marriage of Sania Mirza with Pakistani cricketer Shoaib Malik worthy of headlines and probing but not as much on inflation. Apparently, there has been a bit of complacency among the managers of the economy. Complacency is a trap, which reverses the journey and loops back the path of progress to its starting point. There is a hope that the arrival of Rabi crop and the softening of international prices will reduce commodity prices in India and thereby inflation. Fortunately, that may happen. Unfortunately, there are still too many ifs and buts. Monsoon, for one, may turn out to be excessive. The sharp rebound in demand as reflected by IIP and other indices indicates that capacity utilisation is near maximum in many sectors. Unlike the previous cycle of 8.5-9% GDP growth, when the rise in demand provided the private corporate sector with adequate time to boost capacities with capex plans, demand expansion has been sharp during this cycle of the recovery and the business investment cycle is yet to shape up to serve the increased demand. Consequently, supplies will follow demand but with a lag and are likely to feed the inflationary fires in the meantime. Indian experience ruminates that, prices once go up, they hardly come down'. There is an apparent need for civil society to engage monetary authorities, government and the traders, use their weight to raise issue at the appropriate forum and get media to highlight the deleterious impact of inflation. If this menace is not dealt with severely, it has the potential to paralyse the growth of Indian economy and dampen the spirits of poor and middle class of India who have been the bedrock of economic growth. Inflation will be a nagging issue for India because: (a) We are a nation with a large population, which is underserved in terms of food, clothing, housing, etc, (b) Indian GDP is on the trajectory of high trend growth rate of over 8% and GDP per capita is growing at the rate of 7.5%. There is significantly high unsatiated demand at current level of economy, which is bound to rise

significantly further as the GDP per capita increases. Hence, the managers of Indian economy have to address the issue of inflation with short-, medium- and long-term perspective. Hitherto before the issue of inflation, has been handled on as and when basis.' It would be important to insist on the Reserve Bank of India to keep inflation targeting always at top of its agenda. The success and failure of their management must be viewed with reference to the level of inflation that the nation experiences. The political economy should be managed with the underlying philosophy that government policies and programme do not infuriate and/or create propensities of inflation. The issue of food demands immediate action. One is happy to know that the PM has held a meeting on the issue of inflation and created three groups to submit recommendations. However, in the immediate all-out efforts should be made to increase supplies by releasing domestics stocks, which should be complemented with imports, wherever necessary. This should help stockers and hoarders decipher that it does not make business sense to act contrarian. The short-term solution can be to put in place the distribution in order by allowing the entry of private retailers who can modernise the supply chain for meeting the procurement requirements. This should facilitate in contracting the number of rent-seeking intermediaries who appropriate a very large and disproportionate share of value addition and discourage private investment in agriculture. This may eventually help in modernising agriculture, raising yield and thereby making greater supplies available to the market. Along-term answer to the burgeoning India's needs of food products is the second green revolution only, which can be enabled by: (a) attracting private investment, (b) bringing in new technology, (c) introducing high yield seeds and (d) better irrigation tools, techniques and facilities and (e) consolidation of holdings. This has to be supplemented by revolutionising supply chain management. Similar (customised) approaches should be pursued for all other essential items. This will be necessary for at least two decades and thereafter the economics of demand and supply and monetary policy management will hopefully take over as in the case of developed economies. A deprived society, in particular cannot withstand the pain of more than moderate inflation. It will brew social disquiet, which when reaches the level of acidity, engenders disorder in the functioning of the society.

Managing Inflation Risk

As the capital markets have improved, more investors have shifted their concern from weathering the financial crisis to anticipating the inflationary effects of rising federal spending and debt. Many people are asking how they can prepare for potentially higher inflation. This article explores two basic ways to address inflation uncertainty and highlights asset groups that may prove useful. As you consider strategies, remember the difference between expected and unexpected inflation. Asset prices already reflect the market's expectations about future inflation, given all available information. Inflation may turn out to be worse than expected, and this risk of unexpected inflation is what some investors may want to manage.

Hedging vs. Total Return Strategies

Investors can prepare for unexpected inflation by following one of two basic strategieshedging the immediate effects of inflation or earning a total return that outpaces inflation over time. Hedging involves choosing assets whose value tends to rise with inflation. Although holding these assets may reduce the total return of a portfolio, the positive correlation with inflation can help an investor keep up with rising consumer prices, at least over the short term. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.) Candidates for hedging include retirees, fixed income investors, and others who would experience a diminished living standard during an inflationary period. These investors are willing to forfeit long-term growth potential for more immediate inflation protection. In a total return strategy, an investor attempts to outpace inflation by holding assets that are expected to earn higher real (inflation-adjusted) returns. This investor is willing to give up shortterm inflation protection for an opportunity to grow real wealth. Younger investors are typically well suited for this strategy because they have many years until retirement and expect their earnings to advance faster than the inflation rate. As they save and invest for the future, they can accept more risk through greater exposure to higher-return assets, such as stocks. To insulate a portfolio from unexpected inflation risk, both strategies may employ some combination of stocks, short-term fixed income, and Treasury Inflation-Protected Securities (TIPS). Let's consider each of these:

Stocks

Equity securities have provided a positive inflation-adjusted return over the long term. From 1926 through 2008, the total US stock market, as measured by the CRSP 1-10 Index, outpaced inflation by an average of 6.16% per year.1 To achieve this higher expected real return in stocks, however, an investor had to accept more risk, as measured by greater volatility in returns, and endure periods when stocks did not outpace inflation. As a result, stocks may be less effective for hedging short-term inflation and more suitable for investors who want to beat long-term inflation by earning a higher total return. Some investors assume that high inflation leads to lower stock market performance, while low inflation fuels higher stock returns. In reality, inflation is just one of many factors driving stock performance. US market history since 1926 shows that nominal annual stock returns are unrelated to inflation.

Fixed Income (Bonds)

Higher inflation can hurt bondholders in two waysthrough falling bond market values triggered by rising interest rates, and through erosion in the real value of interest payments and principal at maturity. This inflation exposure tends to impact the prices of long-term bonds more than those of short-term bonds, and investors can mitigate the effects of rising interest rates by holding shorter-term instruments. Many types of investors may benefit from holding short-term bonds. When interest rates are climbing, a portfolio with shorter-term maturities enables an investor to more frequently roll over principal at a higher interest rate. This can help inflation-sensitive investors keep up with shortterm inflation and enable total return investors to reduce portfolio volatility, which can lead to higher compounded returns and growth of real wealth.

Treasury Inflation-Protected Securities (TIPS)

Issued by the US government, TIPS are fixed income securities whose principal is adjusted to reflect changes in the Consumer Price Index (CPI). When the CPI rises, the principal increases, which results in higher interest payments. At maturity, an investor receives the greater of the inflation-adjusted or original principal. The inflation provision enables TIPS to preserve real purchasing power and hedge against unexpected inflation. TIPS are generally a good short-term inflation hedge since principal is adjusted for changes in the CPI. They are also a good portfolio diversifier for some long-term investors due to their negative correlation with equities and relatively low correlation with most types of fixed income assets. TIPS were introduced in 1997, so these correlations are based on a relatively short sample period.

However, keep in mind that TIPS prices also have been affected by changes in real interest rates, so TIPS may not track inflation one-to-one in the short term or over longer periods of time. In fact, TIPS can lose market value if real interest rates increase.

Commodities
Commodity futures, as well as gold and oil, are perceived as effective inflation hedges because their returns are positively correlated with inflation. But commodities are more volatile than stocks, and their returns do not always rise with inflation because of this significant volatility. So adding these assets to a portfolio may increase real return volatility, which could offset the benefits of hedging. Investors should also consider the economic argument against holding commodities. Unlike stocks, commodity futures do not generate earnings or create business value. They are essentially a speculative bet in which there is a winner and loser at the end of each trade. Moreover, a broadbased stock portfolio already has significant commodity exposure through ownership of companies involved in energy, mining, agriculture, natural resources, and refined products.

Summary
While the media have featured divergent opinions and theories about the effects of recent government actions on inflation, no one really knows how consumer prices will respond to the complex forces at work in the economy and markets. Investors should carefully review their financial circumstances and investment goals before making changes to their portfolio. As you assess your exposure to a high-inflation scenario and form a strategy that reflects your financial goals and risk tolerance, consider that:

Expected inflation is built into asset prices. In our view, markets efficiently integrate all known information into prices. Thus, current prices already reflect expectations of future inflation. Only unexpected news will affect the inflation outlook. Hedging unexpected inflation has a cost. Investments traditionally regarded as effective shortterm inflation hedges have lower historical returns than stocksand some have much higher volatility. Volatility matters. Evaluating assets solely on their ability to track inflation disregards the effect of volatility on returns and risk. Some assets that are positively correlated with inflation have large return variances, and adding these to a stock and bond portfolio may increase overall volatility.

Even with the prospect for higher inflation, investors who take a total return approach may be better served than those who choose assets based on correlation with the CPI. By choosing assets with higher expected long-term returns and maintaining broad diversification, investors can seek to grow real wealth and preserve the purchasing power of their dollars.

Submit comments or suggestions for future topics.

1. Real return calculation: (1+CRSP 1-10 Index return)/(1 + US CPI)-1. The CRSP 1-10 Index is a market capitalization weighted index of all stocks listed on the NYSE, Amex, NASDAQ, and NYSE Arca stock exchanges. CRSP data provided by the Center for Research in Security Prices, University of Chicago.

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party. Inflation is typically defined as the change in the non-seasonally adjusted, all-items Consumer Price Index (CPI) for all urban consumers. CPI data are available from the US Bureau of Labor Statistics. Stock is the capital raised by a corporation through the issue of shares entitling holders to an ownership interest of the corporation. Treasury securities are negotiable debt issued by the United States Department of the Treasury. They are backed by the government's full faith and credit and are exempt from state and local taxes. CRSP is a non-profit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks, both active and inactive. OTC bulletin board stocks are not included. The indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results, and there is always the risk that an investor may lose money. Diversification neither assures a profit nor guarantees against loss in a declining market.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.