The Fed and Price Stability
Inflation is a decline in the purchasing power of a currency. In the U.S., that would mean that the U.S. dollar buys less and less over time. Politicians do all kinds of things that add to inflation, but in most countries with an independent central bank, people rely on the monetary authority to keep inflation in check. “Price stability” is included in the mandates of 100% of central banks around the world.
The Federal Reserve Act of 1977 modified the original act establishing the Federal Reserve in 1913, and explicitly states that the Fed’s goals should be "maximum employment, stable prices, and moderate long-term interest rates." Stable prices and moderate long-term interest rates are closely allied and thought to be largely the same objective. Thus, maximum employment and price stability are often described as the Fed’s “dual mandate” because economists often view these two objectives as somewhat in tension with each other.
To most people “stable prices” means zero inflation, but apparently not to the modern Fed. They are willing to declare victory at an inflation rate of 2%. Until 2022, their emphasis was more on stoking employment than in protecting the purchasing power of savers and investors. Investors may need to protect themselves from inflation and not count on the Fed doing it for them.
How is Inflation Measured?
There are several ways of measuring inflation. The favorite of the Federal Reserve is the Personal Consumption Expenditures Price Index calculated by the Bureau of Economic Analysis. For a long time, the Fed has been saying that their target inflation rate is an average PCE inflation of 2%. PCE inflation tends to be somewhat lower than inflation measured by the Consumer Price Index because it allows for the substitution of goods and services as prices changes, reflecting the fact that people will shift their spending patterns to avoid higher costs and take advantage of lower costs.
The Consumer Price Index is the most widely used measure of inflation. It is calculated by the U.S. Bureau of Labor Statistics based upon a relatively fixed (but periodically revised) basket of goods and services. One of the changes was to switch from directly measuring changes in owner-occupied housing prices to a “rental equivalence” concept. Given how quickly housing prices have escalated until very recently, some observers say that 2022 inflation would have been in double-digits under the old methodology.
Two important uses of the CPI are the annual cost of living adjustments in Social Security benefits and the adjustments to principal and interest income for Treasury Inflation-Protected Securities (TIPS).
The graph below shows a monthly history of the CPI since the early 80s, when Paul Volcker broke the cycle of inflation by raising interest rates dramatically and causing a recession. Since then, inflation was on a general downward path until late in 2021, when year-over-year inflation has spiked up to its highest level in over 40 years.
Why You Should Care About Inflation Risk
One of the fundamental functions of money is as a “store of value.” We save money in order to spend it later. Most people save primarily for their retirement. Because people are living longer, the duration of retirement is getting longer. It is not uncommon for people who are retiring now to assume that their savings will need to last 30 years.
Inflation is a major risk to a retirement nest egg. Even fairly low rates of inflation will gradually erode the purchasing power of savings to an alarming extent. As shown in the graph below, an inflation rate of only 2% will reduce the purchasing power of $1 to $.56 in 30 years, almost half of its value. At a rate of 4% that $1 will be worth only about $.32 in constant dollars after 30 years, or about 1/3 of its original purchasing power.
Given the large influence of inflation on the purchasing power of savings over time, many investors are paying more attention to the inflation-hedging characteristics of their investments. This article reports on my recent study (first published on July 22, 2021 and now updated) to objectively measure how well various types of investments have hedged inflation risk over the past couple of decades. Specifically, I measured the correlation of various categories of ETFs with inflation. Correlation is a statistic that indicates how two variables behave relative to one another over time. Correlations vary between -1 (the variables always move in opposite directions) to +1 (the variables always move in the same direction). “Always” seldom happens in the real world. A good inflation-hedging investment would be one that has a highly positive correlation with changes in inflation (or more specifically, changes in inflationary expectations).
Using TIPS to Measure Expected Inflation
It is a well-known principle of economics that what matters to markets are expectations and changes in expectations. Market Prices are set based on expectations. If expectations change, market prices change. Consequently, to test for investments that tend to hedge inflation risk, ideally we would want investments that are positively correlated to changes in expected inflation.
Published CPI Index figures are completely useless for this purpose. Actual CPI over the course of a month may have little to do with how inflationary expectations may have changed over the course of that month. Fortunately, there is an objective, market-based way of measuring inflationary expectations at any point in time. It is known as the “breakeven” inflation rate, and is calculated by subtracting the yield on a Treasury Inflation-Protected Security (TIPS) bond from the yield on a Treasury bond of the same maturity. The difference in yields measures the expected inflation rate. Changes in the breakeven inflation rate over the course of a month measure changes in inflationary expectations.
Unlike regular Treasury bonds which pay a fixed coupon rate and return 100% of principal at maturity, TIPS bonds adjust both their principal value and the coupon interest payments every six months based upon the CPI. The principal value can be adjusted upwards or downwards based on the CPI, but at maturity the investor is guaranteed to receive at least par value for the bond. Thus, the yield spread between a TIPS bond and a regular Treasury bond of the same maturity reflects a market-consensus opinion of the expected inflation rate over the life of the two bonds. This is called the “breakeven” inflation rate since it is the rate of inflation that would provide the same return between the TIPS bond and the Treasury bond.
Consequently, the best way to measure the correlation of assets with changes in inflationary expectations is to correlate asset returns with changes in breakeven inflation rates.
FactSet provides historical yields for both constant maturity TIPS bonds and bellwether Treasury bonds at maturities of 1, 5, and 10 years. I prefer to focus on 1-year maturities since shorter maturities are more responsive to changes in inflationary expectations. However, the data series for the 1-year constant maturity TIPS does not start until April 2014 (blue line below). Data for the 10-year maturities begins January 2003 (green line below). Data availability for the 5-year maturities is in between.
I tested the correlation of changes in Treasury-TIPS implied breakeven inflation using two sub-periods: January 2003 to March 2014 using only the 10-year maturities, and April 2014 to November 2022 using only the 1-year maturities. Thus, I used two different time periods and two different definitions of inflationary expectations.
The assets I tested were different types of ETFs, each representing an asset class or sub-asset class. For the most part, I found that the correlations of asset returns to changes in inflationary expectations were similar with respect to both sub-samples, giving me confidence that the patterns I identified were systematic and not time-period dependent.
The table below gives the results of my study. I tested a number of other ETFs in addition to those listed. I found that ETFs in a similar category behaved similarly, so I selected only one to represent the category—generally the one with the lowest expense ratio and bid-ask spread, since I prefer those in most cases. The correlation data in the table is based on as much data as was available for each ETF. In most cases, the ETF inception dates are after the first sub-period began (2003), so those correlations are from different lengths of time within the first sample period. For the second sample period, all of the ETFs in the study had a full set of returns (beginning 2014). Also, recall that the first sub-period uses breakeven inflation using 10-year bond maturities, and the second sub-period uses 1-year maturities. The final column is the simple average of the two sub-period/methodology samples, sorted by correlation from lowest to highest.
In the sections below, I will comment on the relative attractiveness of various categories of ETFs for inflation-hedging purposes.
Clearly, this is the asset class that you don’t want to invest in if you are worried about higher inflation. Correlations with changes in inflationary expectations are strongly negative—if inflation goes up, these assets go down. As expected, the long-term maturities are most sensitive, but even short-term Treasury bonds have a strong negative correlation.
Contrary to the idea that bitcoin is an inflation hedging store of value, the evidence indicates otherwise. I am using bitcoin pricing data from Coinbase, which begins in 2014. Prices before then tended to be even more erratic than after, and there is strong evidence of market manipulation during earlier time periods. Bitcoin appears to be uncorrelated with changes in inflation. It is also uncorrelated with anything else. It may be an interested diversification play for that reason, but it is not an effective inflation hedge.
Gold gained a reputation as an inflation hedge during the 1970s when its price climbed to new heights during that decade’s notorious inflation. Conceptually, it makes sense that gold should be an inflation hedging store of value over the long-term. As discussed below, commodities tend to function that way, and gold is certainly a commodity. But the objective of this study is to measure the inflation hedging value of various assets in the short-term, right when changes are actually taking place. During the two time periods studied, it was a very weak hedge against changes in expected inflation. No doubt other factors affect gold prices, particularly its function as a “safe haven” during times of stress. Inflationary expectations often increase because times are too good and there are fears that the economy is too strong and is overheating. In such an environment, gold prices are likely to fall. Alternatively when recession approaches, inflationary expectations often decline, and gold may rally.
Unlike Treasury bonds, which have only one major type of risk—interest rate risk—corporate bonds have two major types of risk—interest rate risk and credit risk. Their interest rate risk makes them behave somewhat like Treasury bonds, but their credit risk makes them behave somewhat like stocks. Long-term corporate bonds have more interest rate risk, so their sensitivity to changes in interest rates is high but their sensitivity to changes in inflation expectations is very low or negative. Short-term corporate bonds have less interest rate risk, so credit risk is more important, pushing them more in the direction of stocks. Intermediate-term corporate bonds are in-between. However, none of them are very effective at hedging inflation.
TIPS combine two primary characteristics. First, they are a type of Treasury bond, so they behave somewhat like regular Treasury bonds in their interest rate sensitivity and their safe haven status (though not as strongly as regular Treasury bonds). Second, both their redemption value and the coupon payments based on that value are adjusted based on changes in the CPI every six months. On the surface, therefore, it might seem as though TIPS should be the perfect inflation hedge. However, TIPS are still bonds, and they are heavily affected by changes in interest rates. This is particularly true of long-term TIPS. For long-term TIPS ETFs, such as funds that encompass all outstanding TIPS (TIP and SCHP for example), the first aspect swamps the second. Those ETFs are not very good inflation hedges because they have so much interest rate risk. On the other hand, short-term TIPS ETFs (VTIP and STIP for example) have limited interest rate risk, and so their inflation adjustments are more predominant. These are excellent inflation hedges.
It would be logical to assume that real estate (REIT) ETFs should be good inflation hedges, since over the long-term, real estate values tend to rise with inflation. However, my focus is on short-term effects, not long-term effects. In recent years, the value of real estate ETFs (both broad equity REIT ETFs such as VNQ and SCHH and homebuilding ETFs such as ITB and XHB) have been mediocre inflation hedges at best. International real estate ETFs (VNQI and RWX for example) have somewhat better inflation hedging tendencies than their U.S. counterparts. This may be because a jump in U.S. expected inflation can depress the U.S. stock market, but may not affect international stocks as much.
Broad equities have middling inflation hedging characteristics. By “broad” equities, I mean those ETFs tied to stock market indexes that are fairly broad-based, such as large-, mid-, and small-cap stocks, growth stocks, value stocks, and international stocks, including those based on either developed or emerging markets. These are all clustered in the middle of the correlation table. That means that they provide decent, but not exceptional, inflation hedging tendencies. However, unlike some other ETF categories in the table, broad equities are likely to have attractive long-term returns. In the long-term, a high return can overcome a lot of inflation. Also, although the effect is not as pronounced as it was with real estate, international equity ETFs are better inflation hedges than domestic equity ETFs. Emerging market ETFs are a notch better than developed market ETFs.
My definition of “inflation-sensitive equities” includes some categories that are not much better at hedging inflation than broad equities, such as infrastructure stocks and energy stocks, but also some that are noticeably better, such as metals & mining stocks and natural resources stocks. However, as with any niche strategy, it is probably prudent to allocate only a small percentage of a portfolio to any one of these.
Broad commodity ETFs have shown outstanding inflation-hedging tendencies. My favorite among these is Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF (PDBC), mainly because its structure means it can issue a Form 1099 rather than a K-1 at tax time. Most clients hate K-1s. Also, with an expense ratio of .59%, it is less expensive than many commodity ETFs, and it has a very tight bid-ask spread. Even better is Aberdeen Standard Bloomberg All Commodity Strategy K-1 Free ETF (BCI) with an expense ratio of only .25%. Commodity-specific ETFs, such as OIL, may or may not be as effective at hedging inflation as a broad commodity index, but they certainly have more concentrated risks. If you simply want to hedge your inflation risk and you do not have a particular viewpoint on individual commodities, a broad-based commodity ETF is the way to go.
Multi-Asset Real Return ETF
The single best ETF for hedging inflation risk is, in my opinion, SPDR SSgA Multi-Asset Real Return ETF (RLY). It includes exposures to all of the most effective inflation-hedging categories of assets listed in the table. State Street’s website says this fund “seeks to provide exposure to inflation protected securities issued domestically and internationally, domestic and international real estate securities, commodities, and publicly traded companies in natural resources and/or commodity businesses. These companies may include agriculture, energy, and metals and mining companies.” The fund is actively managed and its investment process “relies on a proprietary quantitative model as well as the Adviser’s fundamental views regarding factors that may not be captured by the quantitative model.” With an expense ratio of .50%, this is not a cheap ETF, but its extremely strong inflation-hedging characteristics may be worth the cost. According to ETF.com, RLY has an average bid-ask spread of only .09%, so it trades with decent liquidity.
When I have a client that is particularly concerned about inflation risk, I will often add an allocation (typically 15% to 30%) to RLY within the overall benchmark for their account as a way of tilting their portfolio intentionally towards inflation-hedging assets. I do not directly buy RLY itself, generally, but I monitor its allocations and allow them to influence my own allocations. Because it is a State Street ETF, it tends to invest in other State Street ETFs. These are not always the cheapest, largest, or most liquid ETFs available in a particular category. I sometimes use competing ETFs if they have lower expense ratios or tighter bid-ask spreads.
- The single best ETF for inflation-hedging purposes is SPDR SSgA Multi-Asset Real Return ETF (RLY). It includes many of the most helpful types of investments (TIPS, commodities, inflation-sensitive equities) in one actively-managed fund.
- Short-term TIPS (not broad or long-term TIPS) are excellent for inflation hedging.
- Among single asset class exposures, the strongest inflation-hedging characteristics are in natural resources stocks.
- Broad equities and real estate provide only mediocre inflation hedging, but the returns are likely to be attractive.
- International equities and real estate are somewhat better than their U.S. counterparts.
- Treasury bonds fare particularly poorly during periods when inflation expectations are rising.