Inflation: What can plan sponsors expect?

The Federal Reserve’s (Fed) new policy framework tolerates higher inflation to create a stronger, more inclusive economic foundation. While a post-pandemic spike may be temporary, many are concerned that continued inflation could become a longer-term problem, reaching higher levels than we’ve experienced in recent decades.
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What could drive inflation higher?

Trillions of dollars in stimulus has been injected into the economy. Alongside bond purchases by the Fed, the money supply has increased dramatically. Additionally, the Fed has kept interest rates at historic lows.

Personal savings rates soared during the COVID-19 pandemic, largely because there were limited opportunities to spend, leading to expectations for pent-up consumer demand. As the economy reopens, spending and demand is likely to increase quickly, which could lead to supply chain bottlenecks in areas of the economy where production had previously decreased to match lower demand.

What could keep inflation in check?

Secular deflationary factors may continue to exert pressure on the Fed’s efforts to feed inflation. Worker productivity has been on the rise for some time both due to and in line with ongoing technical innovations. The combination of these forces generally means that in many industries fewer workers are needed, which may lead to continued higher unemployment.

Alongside these factors, the increased savings rates in high-income households may act as a mitigating factor to the pent-up consumer demand noted above, as those households spend less of their disposable income than lower and moderate-income households.

What does this mean for investors?

Some inflation can stimulate growth and indicates a healthy economy as people earn and buy more.

But too much inflation can create serious economic dislocations, hurting stocks and bonds alike. If the Fed delays reacting to inflation, interest rates may be pushed higher, which can undercut investments.

What can plan sponsors do?

There are a variety of buffers that plan sponsors can implement to help protect fixed income portfolios from rising inflation. These include (1) including Treasury Inflation-Protected Securities (TIPS) within their fixed income portfolio options, (2) shortening the portfolio’s duration, and (3) increasing exposure to bonds and currencies that are highly correlated to commodity prices. Active managers can be more responsive in their ability to adjust exposure to inflationary buffers depending on the current or expected inflation environment.

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