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The Boy Who Cried Inflation

Persistent warnings about rising inflation have proved to be false alarms. Could this time be different?

Economists and central bankers have warned about a spike in inflation over and over again since the 2008 global financial crisis, but inflation remained low and investors subsequently numbed to the warnings. Could this time be different? Maybe.

The average inflation rate shrank in each of the prior four decades. It clocked in at 7.4% in the 1970s but declined to a tiny 1.8% in the 2010s. Unprecedented fiscal stimulus didn't lead to meaningfully higher inflation following the 2008 financial crisis, and in 2012, the Federal Reserve established a 2.0% inflation target that it couldn't quite reach. Near-zero interest rates and supportive fiscal policies have, at various points in the preceding decade, led to dire predictions of runaway inflation, but it never happened. No matter the efforts of central banks, inflation remained stubbornly low.

But the pandemic brought unique circumstances and policy responses, and the market showed some panic by driving up Treasury yields during the first quarter of 2021. The Federal Reserve remains committed to low interest rates, and chairman Jerome Powell adopted language in mid-2020 signaling that 2.0% is the target average inflation rate rather than simply a target to hit. In other words, it's possible that after the prior year's economic challenges, the central bank is willing to let the economy run a bit hotter in the near term. There is also the potential that, once vaccinations are broadly administered and freedom of movement resumes, pent-up demand for goods and services coupled with suppressed supply may lead to a near-term pop in prices.

And that isn't the only evolving factor. Beginning in the 1990s, the outsourcing of jobs to the populations of less-developed nations kept wages lower, which, in turn, contributed to bargain prices for many goods. But with many of those countries now emerging out of poverty, that source of price advantage might not be as readily available as it once was. Contrarians argue that this new set of inputs merits fresh consideration of inflation potential, and that it behooves vigilant investors, if they've learned anything from the unexpected market lessons unleashed in early 2020, to reflect on the full gamut of possibilities. If that means heeding cries of potential inflation, now might be the time.

An investor with a diversified portfolio seeking an inflation hedge might consider Vanguard Short-term Inflation Protected Securities Index VTAPX, which has a Morningstar Analyst Rating of Gold. This low-cost fund tracks the Bloomberg Barclays U.S. Treasury TIPS 0-5 Year Index, which includes U.S. Treasury Inflation-Protected Securities with up to five years until maturity. In a situation where inflation explodes, this fund's shorter maturities compared with those of other TIPS funds would prove useful if rates rise to contain the inflation, which is effectively what happened during the first quarter of 2021. Backed by the credit of the U.S. government, the holdings in this portfolio minimize credit risk, and the principal is adjusted upward when the Consumer Price Index rises, resulting in higher coupon payments and a return that keeps pace with inflation. This low-risk profile limits the fund's return potential in bullish markets, but during periods of excessive inflation, it's specifically structured to preserve purchasing power for investors.

An investor less concerned by credit fundamentals and more focused on interest-rate risk might consider an allocation to bank loans, which adjust coupon payments relative to a designated interest rate but require formidable fundamental credit analysis, as leveraged loans are typically made to companies with significant debt on their balance sheets. The robustly staffed team at Gold-rated T. Rowe Price Floating Rate PRFRX has a record of deftly selecting loans for its portfolio through varied market environments, and in the event of significant inflation, it offers investors a source of yield without excessive interest-rate risk.

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