Inflation: Price Hikes and Wage Spikes

This word inflation is thrown around a lot these days, but where do investors usually see it first? And how has it been combatted in the past? Jose Torres, Interactive Brokers’ Senior Economist, joins Cassidy Clement, Senior Manager of SEO and Content to discuss these foundational questions.

Summary – Cents of Security Podcasts Ep. 26

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Cassidy Clement

Welcome back to the Cents of Security podcast. I’m Cassidy Clement, Senior Manager of SEO and Content at Interactive Brokers. Today, I’m your host for our podcast and our guest is Jose Torres, Interactive Brokers’ Senior Economist. We’re going to discuss inflation. This word is thrown around a lot these days, but where do investors usually see it and how has it been combated in the past? Welcome to the program, Jose.

Jose Torres

Hi Cassidy, great to be here. Thanks for having me.

Cassidy Clement

Sure. Welcome back. I know you’ve been on a few different episodes for us. So, our audience can come from a range of backgrounds. Usually with this podcast channel, we tend to look at beginner investors who are new to the financial space. So what exactly is inflation and where have we seen it in history? Cause a lot of people probably are used to it in their History 101 where we talk about, you know, the depression, the 80s, 2008, things like that. What is inflation? Where have we seen it?

Jose Torres

Sure. So inflation is the overall rise in prices. So as time goes on, prices generally increase due to factors like population growth and monetary currencies increasing their supply. In terms of where have we seen it in history, well, we’ve seen it throughout history. What we’ve seen is shifts in the speed of inflation year by year. So most recently, for example, we saw inflation reach significant highs back in 2022 following the pandemic. And following the pandemic, we had two distinct types of inflation. One kind of inflation is demand push and the other kind of inflation is supply pull. And following the pandemic we had both of those kinds of inflation. And from the demand side what happens is, if you have some kind of monetary policy accommodation or some kind of structural shift that makes consumers spend an abnormal amount, then that leads to demand pushing prices higher. Because there are so many consumers spending and there are limited supplies of goods and services, businesses respond by increasing prices.

On the supply side, if goods and services are limited, then what ends up happening is that consumers and businesses end up raising their bids so that they can get their hands on goods and services. So early in the pandemic, we remember costs for some things, like disinfecting wipes and cleaning materials, were in a shortage and that resulted in the price increasing, right? That’s inflation from the supply side.  We also saw a significant amount of household checks being distributed for unemployment purposes, for general stimulative purposes, to replace payrolls and all that. All those funds that were distributed ended up in demand increasing, right? And that also pushed inflation higher because there was just so much spending going on. So those are the two main drivers of inflation from the supply side and the demand side. We also saw some inflation prior to the 2008 financial crisis that made the Fed hike. We also had some inflation prior in the 90s that made the Fed increase rates in an effort to bring inflation down.

Cassidy Clement

So when you mentioned the different types of inflation, I guess the freshest in everybody’s mind is likely COVID. But there were some companies where they would be able to charge higher for their products because as you said there was more money floating around, there was more spending happening and the demand versus the supply was usually pretty in inverted in a way. There was a lot of demand for toilet paper, but there wasn’t that much supply, etcetera. But what are some normal indicators that you look for with inflation? I’m sure any business student starting out would hear the acronyms CPI and I think the other one would be PCE that you usually learn about initially in Economics. What do you normally look for for the indicators?

Jose Torres

One of the main inputs that I like to look at are commodity prices, right? So that’s oil, copper, gold, silver, etcetera. And then I also look at the producer price index and that’s the PPI and that tells.. historically it was.. they changed the name. It used to be called ‘wholesale inflation’ and that’s pretty much the inflation that goes on between manufacturers and suppliers before consumers experience those price increases. Then you have the CPI, which is the consumer price index. So that’s pretty much the prices that we pay at supermarkets or at shopping malls. And then you have PCE like you said Cassidy, which is the personal consumption expenditures index, and the Fed prefers that index. They feel that it’s a more reliable gauge of price pressures. Also, with all those indicators, the Fed likes to look at the core aspects, which exclude food and energy, because food and energy can be very volatile and sometimes noisy and distract the indicator from the underlying price trend. You know, sometimes you can have inflation and services and goods being subdued, but food and energy being ridiculously high sort of show a part time temporary kind of inflation. Transitory, if you will.

Cassidy Clement

And a personal anecdote, I guess, or a personal reference. I know during some of the earlier rate hikes out of the COVID pandemic where we started to break out of those the low numbers or even the zeros, that phrase you mentioned, core inflation, that was referenced a lot. So is that normally what people can hear or can tie to the reference of inflation? Or is the inflation that includes, I think you said it was, was it food and shopping is that, does that have another word for it or at least a financial vocab word?

Jose Torres

No, I don’t think so. I think for individuals, overall inflation is actually more important than core inflation. Core inflation is important for the Fed. But for individuals, for households, overall inflation is integral because folks put gasoline in their cars. Folks, we have to eat, we have to feed our family members and when you look at it, gasoline and food actually end up being a high share of folks’ budget, you know.

I wanna say off the top of my head somewhere around 30%. So core does remove those two important aspects. Again- to see more of the medium to long term trajectory of price trends without the noisy volatility that food and energy sometimes are characterized with. And part of the reason why food and energy are volatile is you have a lot of conditions around the world, be it geopolitical conflicts between oil exporting countries or you can have droughts that affect food supply. You could have storms that negatively affect food supply as well. And there’s oil supplies as well. So that’s what makes oil and food more vulnerable. Whereas you know goods and services also have to deal with some of those considerations, but not as directly.

Cassidy Clement

Yeah. So the reason I asked that, and I know we’ll be doing a podcast on this separately. But the reason I asked that is because the word inflation gets thrown around a lot and depending on what it is referenced or how it is referenced matters because of the volatility, the vulnerabilities, the risk potential of different things to other issues in the outside world. Those are key points that I wanted to make for people looking at different inflation items. But you said a lot about household shopping and what goes on in the day-to-day of the consumer versus that larger picture of just the the country as a whole. So where do people see inflation in their day-to-day life?

I mean, a lot of people say oh everything’s so high in price, so we know that there’s a purchasing power balance shift. Lower income consumers might have a tougher time. There may be some debt service costs associated. What are the main ways that people can see this in a day-to-day? And go, oh, inflation seems to be creeping up.

Jose Torres

Sure. So one of the main places is of course- everyone’s heard the phrase “pain at the pump”, right? When they’re pumping up their cars and it used to be maybe $40 and now it’s, you know, $60 or $65. So that’s the most obvious one and it’s very transparent too, right? Cause when you fill up your car, it’s all controlled, especially if you visit the same gas station. So it’s “I’m used to paying this much so now I’m paying this much”.

But then in other areas there’s been some pressure on behalf of servicers to push consumers to tip in areas where it wasn’t so traditional to tip maybe a decade or two ago, right? So nowadays in coffee shops, for example, some, not all servicers are pushing their employee compensation packages partially on to the consumers. For example, if you get a coffee, for example, the tip automatically shows up as 20%, right? Now whether that’s too high or too low, of course, that’s a personal judgment. But that’s a shift in what we’ve seen where in the past, if you went to a coffee shop and you got coffee, you know, 20% tip wasn’t typically part of that shopping experience.

We’re seeing some servicers also increase the mandatory gratuities when parties with four or more, in some cases in, in all parties, if it’s just one person, you know. So that’s sort of how we’re starting to see inflation. And then of course, in the costs of things and services that we like and just seeing those things increase, of course that causes some pain and constrains the budgets.

In terms of debt service, a lot of folks took on debt during the pandemic when rates were really, really low, particularly mortgages. And in the US, most of our mortgages are fixed rate, almost all. So, folks really haven’t felt that shift from the debt service side. That’s been more of a shift that we’ve seen in the in commercial real estate where those rates are floating. So office landlords are having a lot of trouble paying those bills in an environment now where there’s a lot of remote work. Also in other countries, in Canada and in the United Kingdom, we’re seeing some trouble with their mortgages because their mortgages, actually a lot of them, they’re not fixed, they are floating rate mortgages. So if inflation goes up, then the rate that they’re paying on their mortgage goes up. So that’s they end up having to pay more, to your earlier point on debt service.

And those are some ways that we see inflation in the day-to-day life. And of course, paychecks are also higher, right? So that’s another way. We are getting paid more in aggregate and that’s of course something that we see as well.

Cassidy Clement

So, we’re going to shift here- from an investment perspective, how would investors try to curb inflation with what they would put their funds into or maybe their potential portfolio diversification? What would you say are the normal processes that people use? Or changes within the financial products or securities in portfolios as inflation increases.

Jose Torres

Sure. So one thing that comes to mind is the TIPS: treasury inflation-protected securities, right? And those are bonds that adjust as inflation shifts. So that’s a way to protect against inflation. Also, when you have volatile inflation, you have volatile interest rates, right? And when selecting stocks, one has to be cognizant of which stocks and which sectors are better positioned to withstand a higher interest rate regime. And that, generally speaking, tends to favor quality and value.

Quality because when balance sheets are strong, interest rates going higher are less of a detriment than if balance sheets were weak. So we’d want to be more in quality rather than in riskier balance sheet companies. And then in terms of growth versus value, we’d want to be more in value rather than growth in an inflationary regime because the earnings of growth stocks are priced out distant into the future.  And when you discount those future earnings into the present with a high inflation and a high interest rate, that weighs on their earnings prospects. Whereas value companies are earning money right here, right now. So it helps because if you think that inflation is going to be high for the next 10 years, for example, then a growth company that’s going to make X amount of dollars in 10 years, you don’t know in 10 years how much those dollars are going to be worth.

But with the value stocks you have earnings right here, right now. And you have a shorter-term window in terms of the inflationary outlook and what you can do with those earnings. Other inflation-friendly investments are things like energy and materials because you’re so close to the inputs. So close to oil, so close to copper. As inflation rises, the selling prices for energy producers and materials producers increase as well. And there’s less of a detriment on margins for them.

Cassidy Clement

So when it comes to financial institutions and the government, how exactly do they combat inflation? I mean, everybody talks about the interest rates and how the Federal Reserve acts. And again, that’s a different topic for us. But generally, what are the ways that those bodies try to combat inflation?

Jose Torres

Sure. So the government tries to combat inflation. On the fiscal side, it should be by lowering fiscal spending because by increasing fiscal spending that’s increasing inflationary pressures in the pipeline by increasing demand. And on the monetary side, this is where central banks are important. The role there is to increase interest rates. And engage in other kinds of operations related to bond buying. And in some cases like with the Bank of Japan’s yield curve control and the US with the Fed, that’s quantitative easing and quantitative tightening. So in an inflationary regime like what we’ve been in for the last couple of years, the Fed has been increasing interest rates and they’ve been declining their share of U.S. Treasury ownership in an effort to transfer more of the shares to price sensitive private markets, private investors rather.

And also constraining economic activity by increasing interest rates. And what that does is that it cools inflationary pressures because folks that want to borrow and invest can’t borrow and invest as easily. They can’t employ people as easily. There are less transactions. Particularly now we’re seeing it with home purchases, there are less transactions with goods.

All of the people that get paid when a house gets sold, or when refrigerators or furniture or airplanes or those kinds of expensive goods, automobiles. When they get sold, all those people, banks, sales representatives, inputs providers, all those people aren’t getting paid when the transactions decline and that leads to a reduction in inflationary pressures.

In terms of financial institutions and how they manage inflation, it’s by pretty much trying to forecast it and by managing investments. So for example, if they think that inflation is going to come down, then maybe investing in bonds that are a little more on the duration curve, maybe 2 to 5 to 10 years.

But if they think that inflation is going to spike, then they’ll only invest in bonds that mature in three months or less or six months or less. So, managing the duration curve and managing the lending is important for financial institutions.

From the lending side, if a financial institution feels that inflation is going to rise dramatically, then that financial institution shouldn’t be lending a lot of long-term debt, right? Because if it’s 2021 and I think inflation is going to go high in the next five years, why would I lend to you at 2% if inflation is going to be 7% in two years, right? Because all of a sudden, I could have waited and lended to someone else at a rate that was more proportionate to the inflation rate. So, I think that’s really one of the main things that financial institutions do when it comes to managing inflation.

Cassidy Clement

These are all really good points and very helpful pieces for people to think about when they’re reviewing. Whether it’s fed announcements, inflation reports, etcetera. So thank you for joining us, Jose.

Jose Torres

Thanks for having me, Cassidy. It was a great time.

Cassidy Clement

Sure. So as always, listeners can learn more about an array of financial topics for free at ibkrcampus.com, follow us on your favorite podcast network and feel free to leave us a rating or review. Thanks for listening!