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By Christine Benz | 10-18-2017 02:00 PM

Don't Be Complacent About Inflation

An unanticipated rise in inflation could hurt your portfolio, even if the absolute level remains low, says Vanguard economist Roger Aliaga-Diaz.

Benz: Is the fact that inflation in the U.S. is so low, does that mean the lack of wage growth is less of a concern then perhaps it otherwise would be?

Aliaga-Diaz: That's a good point. Certainly that has been part of the mystery and the puzzle that many economists are referring to today, even including Chairman Yellen. The fact is that wage growth is driven by three key factors. The main factor is the strength of the labor market and unemployment. Clearly on that account that's not producing stagnant wage growth--on the contrary it's starting gradually to push wages up to a normal level. The fact is that in addition to unemployment there are other factors that are suppressing that wage growth, that are offsetting this upward pressure from labor markets. One of them being productivity growth.

When we say labor productivity, economists, we mean the ability of workers to contribute to production and to, more tangibly, begin to contribute to the generation of profits for the company, by leveraging technology, by leveraging capital. That productivity growth has remained very low even since before the financial crisis by a factor of 1% to 2% lower than normal. That, in economic terms, translates one-for-one into lower real wage growth. 

Finally, the third component of wages is the cost of living adjustment, inflation that you referred to. Because inflation is low that cost of living adjustment has been also low. Certainly, I agree with you, if inflation is low it does not affect the purchasing power of the salary that much, on that account. The reason why the Fed is worried about inflation is not about wages, it's really about proving to the markets that their monetary policy tools still work in terms of being able to push the economy out of a deflationary trap or to push economy out of a recession. This is more about showing the market that they are ready for the next recession than about increasing wage growth.

The Fed can do very little about productivity growth, to be honest. Their ability is more to fight unemployment and labor market slack. But that trend of productivity that is driven by technology, by capital investment, by long-term decisions of companies sometimes is not that effective in monetary policy. So that's a little bit of a challenge there.

Benz: It's not in the Fed's tool kit. I'd like to go back to inflation. Investors may be not so concerned about inflation or making sure that their portfolios are inflation-protected. They might assume that inflation will stay nice and low for the foreseeable future. Do you think that's a safe assumption to make? How should investors approach that decision?

Aliaga-Diaz: Well it's interesting, normally one tends to think that inflation is low, that is less of a concern. But in reality, basically hedging or protecting the portfolio from inflation is about really protecting from and expecting inflation shocks. It's not about the level of inflation. If inflation goes from 1% to 2% it will have same damaging effect on your portfolio that if inflation rose from 5% to 6%. It's that 1% increase that affects the portfolio. The reason is that traditional asset classes like bonds and stocks are fairly good at pricing in stable inflation even if inflation is high. We see it in some of the emerging markets, where inflation runs 20% perhaps. And you see equity markets do kind of well, I mean they don't lose ground relative to inflation. The problem is when that inflation accelerates faster than expected.

On that account I would say that current levels of inflation and where the market expects inflation to be could actually be too low relative to what we find out later. That need for taking inflation into account is still there even if we are starting from a low level. My only recommendation is not to overdo it in terms of inflation protection, because inflation-sensitive assets such as TIPS or commodities, they have a cost. It's like buying inflation insurance. There is a premium to pay for that, in the case of TIPS you pay it in terms of yields that are a little bit lower relative to nominal yields. In the case of commodities, you will pay it in terms of a little bit higher volatility than normal. So, on risk-adjusted terms the portfolio will pay the price. You are insured against inflation, but you are paying a premium for that. There is a right balance and right amount of inflation protection you want to put in a portfolio. 

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