Let Us TIP You Off, Inflation is Rising
If you have filled your gas tank recently, you may have noticed that your wallet was a bit skinnier when you left the gas station than it was when you tanked up just a few months ago. Fuel prices are a key component of inflation, which is the rate at which the general level of prices is rising for goods and services. The Federal Reserve’s annual target inflation rate is 2% for determining monetary policy. Inflation has been below the Fed’s target rate since the Great Recession, with the most recent annualized reading at 1.9%. However, the six-month annualized rate has recently moved above the year-over-year rate and has breached the Fed’s target by reaching 2.3%.
Over the past couple of years, the Federal Reserve has been slowly increasing short term interest rates by way of small increases to the Federal Funds rate, the rate at which Federal Reserve member banks loan to each other on an overnight basis. However, interest rates are still quite low relative to how far along we are in the economic cycle. One impact of inflation rising above the Fed’s 2% target is that it may cause the Fed to raise short-term interest rates faster than they otherwise would in order to keep the economy from overheating. The intent is to slow down economic activity by decreasing demand. For example, if a company needs a loan to invest in a new project, management may think twice if it has to pay significantly more interest on the loan than previously anticipated. In turn, by foregoing the project, the company may employ fewer people and make smaller investments in raw materials. Hence the economy slows down.
In addition to increasing oil and other commodity prices, there have been other signs of inflation. Decreasing unemployment has led to strong wage growth, which increases labor costs for businesses who must pass these costs on to consumers. The combination of tax cuts and increased spending by the U.S. government may also contribute to further inflation by increasing aggregate demand in the economy.
Rising inflation can have a bit of a domino effect on the bond side of portfolios. As rising inflation leads to increasing in interest rates, increasing rates lead to an unwelcome drop in bond prices. We have taken steps to protect client portfolios by avoiding longer maturity bonds, and increasing our allocation to both Treasury Inflation Protected securities (TIPs) and floating rate loan funds. Our client portfolios hold TIPs and/or TIPs exchange traded funds. TIPs are issued by the U.S. government and protect against inflation by adjusting the principal payment investors receive at maturity by increases in inflation over the time the securities are held. We hold both short and intermediate term TIPs. Intermediate maturities protect against a longer term inflation threat, while the shorter maturity TIPs protect against short term inflation shocks.
As the name suggests, floating rate loans have flexible interest rates that adjust at regular intervals to reflect changes in a short-term interest rate. In many cases, the interest rate measure for these adjustments is the London Interbank Offer Rate, or LIBOR. Floating rate loans are loans to corporations and therefore expose investors to higher credit risk than TIPs. As such, these funds represent a smaller proportion of the bond allocation in client portfolios than the allocation to government backed TIPs.
As we start to see increased inflation we are glad to say that this is a development that we anticipated. Accordingly, in our most recent firm-wide portfolio rebalance, we adjusted bond allocations to protect against future inflation. We believe client portfolios are well-positioned for the current economic environment. As always, please contact us if you would like to discuss this or any other financial topic.