Vanguard experts discuss the delicate balancing act the Fed does when it comes to measuring inflation and any interest rate hikes.

Transcript

Lara de la Iglesia: The U.S. Federal Reserve has increased rates twice so far this year, and they mentioned rising inflation as a partial motive. Most investors think of inflation as a negative, but tell us: Is there such a thing as good inflation?

Gemma Wright-Casparius: That’s an interesting question. It’s important to remember that most central banks, including the Federal Reserve, have a target level of about 2%; not too hot, not too cold. And that’s the rate of inflation that they deem is relatively good inflation. That allows the economy to be calibrated to full employment. And so from the Fed’s perspective, they have this target. It’s not a ceiling. We’ve spent the last nine years pretty much below that ceiling, or that target level, of 2%.

And so what the Fed would like to do is get ahead of inflation running too much above that because they do perceive that inflation significantly above 2% for too long a period of time changes the behavior of consumers. So people think it’s inflationary. They spend more today because it will cost them more tomorrow, and that forces policymakers to pull that lever a little bit harder. And they don’t want to do that. They want a Goldilocks scenario, 2% growth, 2% inflation on average, and the economy can continue to hum along with full employment. And that’s a good thing.

Roger Aliaga-Díaz: The good inflation is the one that is stable and controlled inflation. If the Fed feels that inflation is where they want it to be, that’s good for the market and it’s good for investors, because markets tend to price in whatever the inflation expectation is out there. And in that sense, this idea that inflation erodes the value of your assets, of your wealth, only happens when inflation surprises, only happens when inflation is volatile and unexpected. But if inflation is stable, controlled, and expected, even equity prices, even fixed income assets, can actually factor that into their prices, and then for long-term investors inflation is not harmful.

Lara de la Iglesia: So what about from those surprise situations, though, for any investors that are concerned about that spike or that future inflation? How can they hedge against that in their portfolio?

Roger Aliaga-Díaz: Yeah, that’s a great question. I mean, clearly, there are inflation-sensitive assets. That is, there are assets that can keep track of these movements up and down in inflation much better. Of course, the TIPS market or the inflation-protected securities—bonds.

Roger Aliaga-Díaz: There are other assets like commodities or energy-related sectors of the equity market that may have what we call a higher inflation beta, that is, they’re more one to one with inflation, much closer.

So if your view is that inflation is going to surprise on the upside, it’s going to be much harder than what the Fed expects, which right now would be a little bit difficult to think of, but it could happen. Then those assets could provide a little bit of inflation sensitivity to your portfolio.

However, we have to keep in mind from the investment perspective that there are always tradeoffs.

If inflation goes the other way, if it goes down, then those assets will bring you down with inflation, too, in terms of the returns to the portfolio.

Lara de la Iglesia: Okay, great. Gemma, do you have any thoughts on that?

Gemma Wright-Casparius: TIPS, obviously, protect against unexpected rises in inflation, as Roger said. In some of the work that we’ve done with the Investment Strategy team at Vanguard, what we’ve seen is that the correlation with short-dated TIPS—so zero to five-year TIPS—have much better correlation to realized inflation changes without the volatility that you might see in commodities and in equities and even in nominal bonds, for example.

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