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In our last white paper, “There’s more to inflation risk than meets the eye,” we addressed inflation squarely from the perspective of an asset allocator by examining the various impacts it can have on client portfolios — the idea being that understanding and evaluating a portfolio’s exposure to inflation risk, in all its forms, is the first step to managing it effectively. This time around, we build on that discussion by focusing on the management and potential mitigation of inflation risks.
Specifically, we lay out what we believe are the five most likely sources of inflation risk over the coming decade:
- The global economy running (and growing) beyond its potential output in the years ahead;
- Greater pricing power by the labor market, putting upward pressure on wages;
- Input price shocks caused by the ongoing trend of global climate change;
- Reduced investment in some commodity sectors, creating steeper supply curves; and
- Disruptions to the stability of traditional monetary relationships.
We then present a source-based investment “playbook” of sorts that allocators can follow as they seek to neutralize the looming threat of higher inflation — a top-of-mind concern for many clients in today’s reflationary environment. (For more on that, see “An allocator’s agenda for a reflating world.”)
Why the source of the inflation matters
Many investors rely on standard inflation indices, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI), to track the direction and pace of inflation over time. While useful to a degree, these broad indices are only intended to serve as representative guides to the inflationary forces facing consumers and businesses. They are not designed to help asset allocators tackle inflation from an investment perspective, as that depends on precisely where the inflation is coming from — its source (or sources). For example, a rise in overall CPI inflation caused by “source A” could lead to market instruments repricing in a completely different way than if the same CPI move were caused by “source B.”
Five main sources of inflation
1. Demand dynamic: Potential growth, output gaps, demand-pull inflation
- Overview: Every economy has its own natural ”speed limit,” so to speak, that is determined by the nation’s productive capacity. Demand for production beyond this limit will typically translate into higher inflation as the excess demand bids up production prices.
- Inflationary process: “Demand-pull” inflation usually leads to a general but uneven inflationary impact, with price pressures concentrated in…
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