The Drivers And Risks Of Inflation

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 |  Includes: TIP
by: Fund Gurus

Inflation is a huge problem for investors. It erodes the real value of our savings and often forces us to take on board certain levels of risk just to maintain our purchasing power.

Inflationary pressures seem to be minimal at the moment and this is reflected with the latest US Consumer Price Index (CPI) showing inflation at only 1.5% YoY. However there are certain drivers of inflation that could begin to play out over the medium term that could cause inflation to spike. I will focus on these drivers and then discuss some possible implications of higher inflation and how it could ultimately derail the recovery.

Demographics

We are currently witnessing a growing population and growing elderly dependency ratio. Currently there are around 810 million people over 60 (12% of population), by 2050 it is estimated there will be 2.4 billion people over 60, which will represent 26% of the global population. With more people consuming goods and services and fewer producing them, prices will likely rise, which will be inflationary.

US "Baby Boomers", born between 1946-1964 will begin to approach retirement over the medium term and this will be an inflationary force on the economy. It will reduce the labor force, which will mean workers have more power and could potentially lead to wage inflation, which would result in higher prices for goods and services as costs are passed on to consumers.

Money Printing

Since 2007 central banks globally have printed approximately $9 trillion and this is increasing with the US and Japan still printing and the UK likely to initiate further easing to help stimulate stalling growth.

To date, all this extra money in the system has not been very inflationary, however, at some stage this extra money will likely lead to higher inflation. Velocity of money is very important in determining inflation, and to date we have not really witnessed the printed money flowing through the economy, instead banks have used it to re-capitalize their balance sheets. However, as the US recovery gathers momentum and banks recover, lending rates will increase and the velocity of money should increase, most likely leading to a rise in inflation.

Emerging Market Wage Inflation

Over the last 20 years emerging market nations have helped reduce inflationary pressures in the western world. Emerging markets, due largely to much lower wage costs, were able to produce goods at a lower cost than in developed markets. As such this allowed businesses to reduce prices without cutting margins. The effect was that the economies such as the US were able to consume goods at lower prices. This was actually deflationary for the US.

What we are witnessing now is that wages in emerging markets have begun to increase considerably and fall more in line with more developed nations. In 2012 wages for Chinese urban residents increased by an average of 12.5%. These extra costs are often passed through to consumers in the form of higher prices, which will lead to inflation.

Food Inflation

Bad weather has driven food prices higher. This could be the catalyst for short-term inflation spikes. Over the last decade there have been various natural disasters and extreme weather conditions which have contributed to poor harvests and higher soft commodity prices. If this trend continues then we could experience some short-term inflation spikes. The United Nations Food and Agriculture Organization reported in May 2013 that global food prices increased for the second straight month. This was largely due to dairy and cereals' prices increases and the Organization predicts that cereal prices will continue to increase this year due to unusual weather conditions.

US Central Bank May Encourage Inflation

US Public debt is approaching $12 trillion, or 75% of GDP (Source: Bloomberg). This huge sum is going to be very difficult to pay back and one way is to use inflation as a way of reducing this in real terms. As such the US Central Bank may actively push for higher inflation in order to do this, and if inflation does spike, they may refrain from tackling it straight away in order to first reduce the debt burden.

Implications of Inflationary Spikes

Inflation can be very painful for consumers and investors. Real incomes are often lower during high inflationary periods. If we were to experience a spike in inflation in the near-term it could seriously impact the economic recovery which currently seems underway. Central Bank policy is normally to increase rates to tackle inflation. However, if these rates are hiked before the recovery has gathered enough pace there could be serious implications. Borrowing costs, particularly mortgages will rise. Banks have large exposure to residential and commercial property and an increase in repayments may result in an increase in defaults. Banks may then be left with high quantities of foreclosed properties on their books; alarmingly similar to the recent housing crash! While this is an extreme outcome there are some serious issues with increasing rates too early. If rates are not increased, then inflation may stick around for the medium-term and consumers will feel the squeeze. This could lead to less consumption which will impact on US growth.

Summary

The US is yet to experience a spike in inflation. However, there are some compelling drivers which could cause a spike in inflation over the near term. Some people argue that until velocity of money or wage inflation increases we will not experience high levels of inflation. However, with banks recovering and lending, and unemployment falling, reducing the slack in the economy, these key forces of inflation may begin to increase. Coupled with this there are demographic factors, increasing costs from abroad and a desire from central banks for inflation. As investors it may be time to look at ways to protect against rising inflation.

There are various strategies that investors can employ to try and protect against inflation. We have already written an article about certain types of equities that can help protect against inflation (seekingalpha.com/article/1425411-protecting-your-portfolio-from-inflation). These types of equities generally have their revenues linked to inflation, or have the ability to pass cost increases (such as wage inflation) through to consumers, without significantly impacting unit sales. Inflation linked treasures, whose principal and coupon payments are linked to inflation, will offer returns protection against inflation spikes. iShares TIPS Bond ETF (NYSEARCA:TIP) is available to investors and purchases a basket of US TIPS.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.