Jason Heath: Time horizon and effects of ‘transitory’ inflation are clearly much longer and more widespread than anticipated
Higher prices have become top of mind for Canadians as the one-year inflation rate hit 5.7 per cent in February. This is the biggest annual increase since August 1991, when inflation was six per cent. There are far-ranging implications for workers and retirees and how they budget, invest and plan for retirement.
Over the past 30 years, inflation has averaged 1.9 per cent. The Bank of Canada adopted an inflation-control target in 1991 with a goal to keep annual inflation between one and three per cent and ideally close to the two per cent midpoint of that range. The central bank says it raises or lowers interest rates “in order to achieve the target typically within a horizon of six to eight quarters — the time that it usually takes for policy actions to work their way through the economy and have their full effect on inflation.”
The most recent deviations from the target have been on the downside, notably during the global financial crisis in 2009 and again in 2020 following the onset of the COVID-19 pandemic. Prices temporarily fell year over year in both cases.
Now, inflation has taken hold globally. Annual inflation in the U.S. (7.9 per cent), India (6.1 per cent), and the euro area (5.9 per cent) has been heating up, and most countries in Africa and South America have rates over five per cent as well. In 2021, as inflationary pressures began to build, many — most notably the U.S. Federal Reserve — believed that inflation was transitory or temporary and unlikely to persist. Now, the question becomes, what if it does?
Statistics Canada reported the average hourly wage increased by just 1.8 per cent from 2020 to 2021. If inflation remains persistently high, workers whose earnings cannot keep up with the rate of inflation are effectively getting a pay cut. Employees should consider this in their salary negotiations and business owners should consider it with regards to their pricing and staffing.
As interest rates rise — the natural central bank response to high inflation — those with a lot of debt may also have their cash flow reduced. That cash flow decrease may not be immediate but many mortgage borrowers will see their amortization period increase as more of their monthly payments go to interest and their debt-free date is delayed. This is an important consideration for young homebuyers if they are going to balance their home ownership goals with other priorities like retirement.
An increase in mortgage rates from two per cent to four per cent would require a 24 per cent increase in monthly payments to maintain a 25-year amortization period. Maintaining the same monthly payments after an increase from from two per cent to four per cent would push a 25-year amortization out to over 38 years. High debt levels like we have in Canada are inherently deflationary, but this may not be enough to counteract the global forces at play pushing prices higher.
Modest, steady inflation can be good for the economy and stock market investors, and that is one of the reasons central banks aim to control inflation with monetary policy. Stocks can provide a hedge against inflation but there are caveats. If higher input costs for companies are combined with lower sales due to decreased consumer demand, this can have a negative impact on corporate profits and stock prices. Higher borrowing costs for heavily indebted companies can also impact their cash flow negatively the same way indebted consumers are at risk.
In the short run, high inflation can lead to stock market volatility and to lower real (inflation-adjusted) returns. Historically, value stocks have outperformed growth stocks during inflationary periods, in part because higher rates can benefit stocks with near-term earnings potential and less debt. We have seen this scenario play out as of late, after more than a decade of outperformance for growth stocks.
Higher interest rates can be negative in the short-term for bonds because if a new bond is issued today paying three per cent interest, yesterday’s two per cent interest bond is less enticing to investors. Bonds generally trade in the open market like stocks, and as a result, will typically decline as interest rates rise. The result is that an investor holding bonds, bond mutual funds, or bond exchange traded funds can have a negative return from their fixed-income investments during inflationary periods where rates are rising. The longer a bond’s term to maturity, the more susceptible it is to rising rates. Short-term bonds, real return bonds, and rate-reset preferred shares may be less at risk.
Eventually, higher rates can be good for fixed-income investors who can invest at higher returns. Holding cash in the meantime is a double-edged sword. It can avoid the risk of short-term losses in bonds, but a six per cent inflation rate means $1 in the bank today is only worth about 94 cents after a year.
Inflation’s impact on a pensioner depends on the terms of their pension plan. A retiree with a fixed pension payment is at risk from higher inflation, especially if they do not own stocks or real estate that may provide somewhat of a hedge against higher prices.
Those with indexed pensions may have some protection from higher prices if their pension keeps pace with inflation. Some pensions provide only partial inflation protection, especially when inflation is above certain levels, or annual inflation adjustments may be conditional and based on pension performance.
The Canada Pension Plan (CPP) and Old Age Security (OAS) pensions are indexed to inflation and adjusted annually, in the case of CPP, and quarterly, in the case of OAS. A pensioner can apply for CPP as early as age 60, and in the case of OAS, as early as age 65. Both pensions can be deferred to age 70 and each month of deferral results in a higher pension payment for life.
There are many benefits to deferring these pensions, particularly given the breakeven age when a recipient will have collected more lifetime income is much lower than the average life expectancy for a senior. But because the pensions are indexed to inflation, this recent spike in the cost of living highlights a powerful inflation hedge that is available to nearly every Canadian retiree who opts to defer and increase these pensions.
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If an investor had $100,000 earning four per cent per year and they withdrew four per cent or $4,000 in the first year and increased those withdrawals at two per cent inflation for 30 years, they would have about $26,000 left 30 years later. If inflation was instead four per cent annually, holding all factors constant, those indexed withdrawals would draw the account to zero after 25 years.
That said, a persistently higher rate of inflation would likely lead to a higher long-run return as interest rates and stock market growth would likely be higher. If the investments returned six per cent maintaining a two per cent real (inflation-adjusted) rate of return with inflation at four per cent, the investment balance after 30 years would be about $44,000.
In the short run, higher inflation is concerning and can lead to uncertainty. The Bank of Canada is likely to continue to increase interest rates to counter the higher cost of living. There is a risk the rate increases have taken too long to start or may now happen more quickly than expected, and that may have implications for savers, retirees, the economy, and the stock market.
Although we have become accustomed in Canada to relatively low and stable inflation over the past 30 years, higher inflation domestically and abroad is now on everyone’s radar. It is unlikely to become a long-term, permanent phenomenon, but the time horizon and effects of “transitory” inflation are clearly much longer and more widespread than some policy-makers anticipated.
Source: Financial Post