One of our courses that has proven to be popular in the last few years involves the topic of inflation.  This short note looks at some of the preconceptions that surround the topic.

Inflation – everybody knows what it is!

One of the first things that is asked in the course is what is meant by the term ‘inflation’.  One of the observations from the front of the class is that once you get 15 smart people in a room there is a tendency for them to overthink the problem.  Some of the answers can be very involved but mask a simple idea: inflation is rising prices.

Here’s another test for you; can you define the following terms?

• Deflation
• Disinflation
• Stagflation
• Hyperinflation

Although the course has a section on the economics of inflation I normally ask the participants if they would like to cover the concepts.  To date no one has ever shown any interest in this module, which I find surprising since on many occasions participants often struggle with the fundamental concepts.  This came to mind recently when reading a letter submitted to the Financial Times which asked how inflation from a weak currency differs from to that created from aggressive monetary policy?  This prompted a flurry of replies explaining the difference between ‘demand pull’ and ‘cost push’ inflation.

Inflation is not important

I often tease the younger members of my audience about their experiences of inflation.  They have been lucky enough to avoid the high inflation rates that old timers such as myself witnessed in the UK in 70s and 80s.

Although participants often laugh when I show them the Zimbabwe bank note it does highlight the single most important concept about inflation.  Investors should care only about the goods and services that money can buy, not money itself[1].    One topic that is addressed within the course is the impact of inflation on a fixed coupon bond.  Suppose that you are holding a 10-year bond that pays you \$5 per annum per \$100 nominal.  You decide to use the income to buy yourself a bag of premium coffee beans.  With inflation at 2% per annum by the time your bond matures those beans will cost you \$6.09 so the purchasing power of your final coupon will have fallen by about 18%[2].

Real rates are interest rates adjusted for inflation

Although this is not a myth the problem with defining real rates in such a manner is that it does not give you a sense of what they are and why they are significant.  Thus, people often tend to struggle with concepts such as negative real yields.  To understand real yields, it is important to understand the Fisher equation.  The Fisher equation establishes a relationship between nominal rates, real rates and expectations of inflation.  This is approximated by:

Nominal yields = real yields + expected inflation + risk premium

Here nominal yields are defined as those rates that will determine how much money is received from an investment.  Real rates signal how much today’s savings are worth in terms of future consumption[3].  So, ignoring risk premiums if you had \$100 to invest with nominal interest rates at 1% and expected inflation at 2% you would be mad to stick your money in a savings account.  You’ll be worse off next year so go and spend it!

Inflation-linked bond investors receive a real coupon plus the annual change in inflation

Inflation-linked Bonds (ILBs) pay investors a fixed real coupon with an ‘inflation uplift’.  One common misconception is that if the bond pays a real coupon of, say, 3% and that annual inflation is 1% an investor would be paid 4%.  Although different types of ILB do exist the most common approach is to ensure that the investor’s purchasing power from the date of the bond’s issue is maintained.  So, if at issue the relevant inflation index is 100 and rises to 101 by the end of the year, the ILB will pay 3.03% (3 x 101/100).  If the inflation index moves to 102 by the end of the second year (implying an annual inflation rate of about 1%) the ILB investor will receive a coupon of 3.06% (3 x 102/100).

Breakeven rates reflect expectations of inflation

Over the years, market participants tended to group together the last two components of the Fisher equation and refer to them as ‘breakeven inflation’.  The popular press will often report this number describing it as the market’s expectation of future inflation.  Although this is to true to some extent there are several important factors that are ignored that impact ILB prices and real yields and hence the magnitude of breakevens.

• The relative illiquidity of inflation-linked bonds (ILB).
• Demand and supply imbalances.
• The embedded optionality within ILBs that offer a par floor.
• The relative demand for linkers to asset swap.
• Perceived credit risk of the issuer.

The difficulty is trying to determine which of these factors are relevant at any one time.

Inflation is intriguing and can be sometimes fiendishly difficult.  Underestimate it at your peril!

This course can be offered on an inhouse basis so email us on contact@fmarketstraining.com if you are interested.  For individual participants the course is offered via the ICMA whose website can be found here

[1] Kerkhof (2005) “Inflation derivatives explained.  Markets, products and pricing” Lehman Brothers Research

[2]With \$5 of income to buy a \$6.09 item you can only afford 0.82 of the product.  This is the remaining purchasing power and so the investor has lost 18% of their original purchasing power.

[3]Canty and Heider (2012) “Inflation markets”.