Why Inflation Is a Hot Topic – and How It Affects Investors

Used cars and trucks are a hot commodity in the United States right now: the prices of previously loved sedans, SUVs and pickup trucks have shot up 21 per cent from a year ago, and were up 10 per cent in April alone—the biggest one-month increase ever recorded. Why does the price jump matter if you're not in the market for a set of wheels? In a word: Inflation.

Used cars and trucks are among the items tracked by the Consumer Price Index (CPI), the most widely used measure of inflation. And it's been hard to ignore the attention inflation has been getting, which is due in part to the recent surge that caught some analysts and investors by surprise, as well as forecasts for ongoing increases in the years ahead.

To shed some light on why inflation is getting so much attention recently and why investors should care, we explored market commentary, economist reports and news sources to bring you the following highlights.

First, some recent stats. On May 12, the U.S. Labor Department announced that headline CPI rose 4.2 per cent in April from a year ago (its biggest 12-month increase since 2008), and was up 0.8 per cent from March. Economists had expected inflation to rise, but they predicted much lower figures: 3.6 per cent year-over-year, and 0.2 per cent compared to March. Canada's headline CPI was up 3.4 per cent in April from a year ago.

As a refresher: CPI measures the change in cost of a representative basket of goods and services—such as food, shelter, transportation, energy, household expenses and clothing—over time. An overall rise in prices indicates inflation, or a decrease in purchasing power. (For more, read What is Inflation and How Does it Affect Investors?)

Before the latest U.S. numbers were released, markets had already experienced some sharp sell-offs in stocks, especially tech stocks (whose values are often tied to expectations for high levels of future profitability). After the news broke, U.S. stock indexes slumped further.

“The latest U.S. inflation release contained more fireworks than we, the consensus or financial markets had expected," said Eric Lascelles, Chief Economist at RBC Global Asset Management (RBC GAM), in his latest MacroMemo update.

Central banks, including the U.S. Federal Reserve (the Fed) and the Bank of Canada, normally aim to keep inflation at 2 per cent, which is widely considered a good rate for economic growth. But these are not normal times, as the world continues to deal with challenges posed by the pandemic, and many policy-makers have said they are willing to let the economy “run hot."

Economists have noted that other factors should be taken into account when considering April's unexpectedly high inflation rate, such as:

• Base-year effects: A year ago, the pandemic had shut down much of the economy, and prices fell sharply from February to April. As a result, inflation was particularly low in the “base month" of April 2020 (0.3 percent in the U.S. and -0.2 per cent in Canada), making April 2021's CPI disproportionately high. This is especially true for energy prices, which RBC Economics says are “still being distorted by incredibly weak year-ago comparables." Base-year effects are temporary—the price declines seen in the early months of COVID-19 will soon fall out of 12-month comparisons.
• Consumer demand: In addition to the soaring cost of used vehicles—which account for over a third of the CPI's increase from March to April—prices for other goods and services have gone up due to growing demand and/or limited supply. For instance, lumber, steel and copper costs have skyrocketed as homeowners undertake home renovation projects and vendors struggle with supply issues.

Still, as RBC GAM's Lascelles notes, “the monthly sequence is undeniably ominous…One might dismiss all but the final two months as being roughly normal increases, but the rate of price increase over the past two months has been genuinely aggressive. Over the past six months, the inflation rate annualizes out to a 5.0 per cent increase. That is substantial."

The Bank of Canada and the Fed say the recent spike in inflation is temporary, and that we'll see more moderate levels, closer to 2 per cent, as pandemic-induced pressures start to ease up. If necessary, central banks have ways to prevent runaway inflation, including raising interest rates. Over the longer term, “downward pressures" such as slower population growth and an aging population could keep prices, and inflation, in check.

RBC GAM says the inflation outlook over the next five years is now the hottest it has been in more than 15 years. However, “while the longer-term outlook – for years six through 10 – has also increased significantly, it remains lower than the norm of just a few years ago. So one might say that the market is now expecting fairly high inflation over the next several years, but that the increase is not permanent," Lascelles wrote.

How inflation affects investors

When inflation rises, interest rates tend to rise, too, as central banks try to cool down an overheated economy. This, in turn, can affect different types of investments. For the near future, both the Bank of Canada and the Fed have said they are holding steady on their target interest rates, which are close to zero. Here are a few general points for investors to keep in mind:

• Fixed income: Rising inflation may eat into the returns of fixed-income assets, such as government bonds and corporate bonds, which pay fixed interest rates. If inflation rises higher than a bond's interest rate, the bondholder's real return (return adjusted for inflation) would fall below zero. Rising inflation also reduces the purchasing power of a bond's interest payments and principal. When inflation rises, bond prices fall and bond yields rise (the two are inversely correlated). Find out more in Why Should Investors Care About Bond Yields?
• Stocks: Equities may offer more protection from inflation than bonds do, although one key for investors is diversification. Protection against higher levels of inflation may come from exposure to certain sectors or industries, to companies that are able to pass on price increases to customers without impacting demand. However, investors may worry about the potential impact rising interest rates could have on future company profits.
• Other assets: Diversifying your holdings may help you stay ahead of inflation. Certain investments are historically viewed as hedges against inflation, such as tangible ones like commodities and real-estate assets, as well as some types of bonds.

It's important to remember that each type of investment carries different risks and benefits; be sure to do your research.

For the latest news and analysis, look for Market Commentary under the Research tab online.