Why is Inflation Important to Investors? | Brandon Averill, Justin Dyer | AWM Insights #28

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Episode Notes

You might be familiar with the terms “inflation” and “deflation,” but do you know how they positively and negatively impact us as investors? About 2 weeks ago, the Federal Reserve held a virtual conference where they said they would be willing to let inflation run higher over a certain period of time to make up for lower inflation we’ve experienced in the recent past. So, over the next 10 years they could target a higher inflation rate than has previously been seen.

To understand how this might impact us as investors, Brandon Averill, managing partner of AWM Capital, is joined again by Justin Dyer, AWM’s Chief Investment Officer, to discuss inflation and the implications it has on investments.

Key Topics:

·         What exactly is inflation?

·         What does a quart of milk have to do with how inflation is measured?

·         Why is inflation important to investors?

·         What happens with slow inflation?

·         What is typically considered the ideal inflation rate for the U.S. economy?

·         What is the Consumer Price Index (CPI) and what does it impact?

·         What is the Personal Consumption Expenditure (PCE) and what does it impact?

·         Why has inflation been in the news recently?

Resources:

·         Investopedia has some great resources on Price Level, Basket of Goods, and Purchasing Power

·         Also, be sure to read Dimensional Fund Advisors great article on Inflation’s Impact on Investor

+ Read the Transcript

Brandon Averill (00:00):
Hey, everyone. Welcome to AWM Insights. Again, we're back for a quick hit each week on a timely investment topic that's going to help you to maximize your net worth. I'm Brandon Averill, a partner with AWM Capital, and I'm joined here with the AWM CIO, Justin Dyer. Our conversation this morning is going to jump into a topic that's been in the headlines very recently and we're going to get started on inflation.

Brandon Averill (00:22):
Inflation, for those of you that don't know, we pulled up the definition here that I thought might be helpful. Investopedia defines it as inflation is a quantitative measure of the rate at which the average price level of a basket of selected goods and services in the economy increases over a period of time. It is the rise in the general level of prices where unit of currency effectively buys less than it did in prior periods, often expresses a percentage inflation, thus indicates a decrease in the purchasing power of a nation's currency.

Brandon Averill (00:55):
So will that definition, let's sum it up into something that's actually digestible. At a basic level, inflation is when prices of goods and services increase over time. And what we can expect from that is that consumers can actually buy fewer of those goods with every dollar they've saved. And I think a good example that we turn to on a basic level is really around giving the illustration, for instance, of a quart of milk. What did a quarter milk use to buy you, or how much it used to cost? And we looked back, and some estimates all the way back to 1916, they estimate a quart of milk costs you 9 cents.

Brandon Averill (01:33):
Fast forward to 1966 and we begin to see that cost grow, that now, what does that 9 cents actually buy you? It only buys you a small glass of milk as opposed to the quart. And if we fast forward all the way to 2017, what did that 9 cents buy you? It only bought you seven tablespoons of milk. So really, just to illustrative the effect on your purchasing power. And we're going to get into a lot more nuanced details here. I'm going to let Justin kind of head into that, really kind of explain why is inflation important to us as investors, and then, how do we measure inflation? What goes into that, Justin?

Justin Dyer (02:10):
Sure. Thanks for that, Brandon. Yeah, inflation is bantered about or [inaudible 00:02:15] about rather, and I think people do lose sight of why it is important. It's a great measure of a healthy economy. You need some amount of inflation to keep an economy moving, growing, healthy consumption. And the real driver behind all of that is, if you think about it this way, you don't want inflation to be too high because that would cause a currency, in our case, the US dollar, to lose its value too fast and that would not be good for the US economy. People would not want to buy US goods as a result.

Justin Dyer (02:50):
And counter to that, if prices fall, then people would stop spending money, right? Because your expectation would be such that I'm not going to buy that quart of milk today because it's going to be cheaper tomorrow. And then that just becomes a vicious cycle in and of itself.

Justin Dyer (03:03):
So some amount of inflation is super important to keep an economy moving along and healthy, and approximately, that amount is around 2%. You'll hear that used by the Federal Reserve here in the US as a target. And we'll get into more on the Federal Reserve's target of inflation later on. But as Brandon mentioned, broadly speaking, what the definition of inflation is, there are some critical data points that you'll hear within news articles and financial media, and that is the consumer price index or CPI. That's probably what you hear most commonly out there. And actually, a version of that or a subset of that is used for social security adjustments each and every year.

Justin Dyer (03:44):
So again, it is a incredibly important data point. And then another really important one is called the personal consumption expenditures, PCE. That one's kind of a mouthful and that's actually what the Fed uses, the Federal Reserve uses for their policy setting needs.

Justin Dyer (04:00):
Again, both of the CPI and the PCE measure a basket of goods in any point in time to figure out what the inflation level is within an economy. And you can make the argument that that basket of goods may not be representative of what people consume in a given point in time, however, that basket of goods does change over time and they try and do make it so that it is actually representative of the overall economy and what people are buying.

Justin Dyer (04:32):
So I'll stop there, Brandon, and let you take over. Hopefully that's a good entry level.

Brandon Averill (04:37):
Yeah, no, I think it's great. And I think kind of just putting a little bit of a bow on it as well, as investors, why inflation's important, and it really comes down to this is why we invest, right? We need our money to grow, so that way, we can use our dollars that we're saving today to buy more in the future. If we take that old adage and just stuff the money under the mattress, we're essentially losing our purchasing power over time. So as we set a target or the Fed sets a target for inflation, we need to be able to grow our money in excess to that inflation in order to purchase more goods in the future.

Brandon Averill (05:13):
So as investors, that's where it really comes into play. It affects the economy certainly. But we look at it from an investment perspective and you always want to be outpacing inflation, which has happened significantly over time, even on the bond side, US treasuries too, certainly the equity markets.

Brandon Averill (05:32):
One thing that the reason why inflation has been in the news recently, Justin, is that the Fed changed its positioning on how it's going to measure inflation. I would love for you to hit on that a little bit just to educate people where we're at on that and how we're looking at it.

Justin Dyer (05:46):
Sure. Yeah. So I put this into the category of some inside baseball Fed speak, if you will, but you're totally correct, Brandon. About two weeks ago, I believe it was, when the Federal Reserve had a virtual conference that they do each time this time of year, they explicitly stated they're going to relax a detailed or specific target of inflation. I referenced 2% early on. It used to be that that was a very specific target for inflation that the Fed expressed out to the marketplace.

Justin Dyer (06:19):
And what they did differently, there's some nuance to this, but it is potentially pretty impactful, is that they said they would be willing to let inflation run hotter or higher over certain periods of time to make up for lower periods of inflation in the past. So over the last 10 years, inflation has been a little bit lower than 2%. So applying their new framework over the next 10 years, they could target inflation above 2% to make up for that, to catch up if you will. And then over that say 20 year period of time, they would like to see a 2% average.

Justin Dyer (06:54):
So basically, they've said instead of an explicit 2% target, they would overshoot it on the high side to catch up for periods of weaker inflation in the past. So what does that potentially mean? It means that we may see higher levels of inflation than we've seen in the recent 10, 20 years. It's been about that timeframe, I would say 20 years on the long side where inflation has been lower than average for quite some time. So going forward, we might see, if the Fed is good at their job and can implement what they're hoping to implement, we might see inflation tick up here.

Brandon Averill (07:30):
That's great, Justin. And for everybody listening, I know we got a little geeky this week, dug into something a little more technical. We'd love to hear from you guys if this was helpful, if you guys want to hear more of this type of stuff from us or if you favor some of the previous AWM Insights.

Brandon Averill (07:46):
So thanks so much for listening to the AWM Insights this week. We really appreciate it. If you found this helpful, want to stay updated with additional content and future episodes, then please visit the website, www.AWMinsights.com and subscribe to our newsletter. Additionally, if you enjoyed this podcast, it would be hugely helpful if you could leave a five star review for us wherever you are listening to this. It really goes a long way in helping others like you to discover the show and get actionable insights to unlock the full potential of their wealth for maximum impact in all their lives, which, as most of you know, is our mission here. And with that, we'll see you next time on the AWM Insights. Until then, stay humble, stay hungry and always be a pro.