How to navigate inflation

There isn’t a pocket of the economy that hasn’t felt the effects of inflation lately. Persistently higher prices can put a dent in consumers’ wallets and business’ profit margins.

It’s a challenge for investors as well. Inflation erodes the real value of investment returns, deflating purchasing power over time.

As a consumer, you may reevaluate your budget to see where you can trim costs or rebalance spending. As an investor, you may consider diversifying portfolios with assets to help hedge the risk of inflation.

For those looking to understand the current inflationary environment and potential ways to invest, Morgan Stanley Wealth Management breaks it down.

Inflation is the rate at which the cost of goods and services increases over time. It’s usually driven by factors that affect supply and demand dynamics: Generally, when demand outstrips supply, prices tend to rise.

Let’s examine the current environment: During the COVID-19 pandemic, demand shifted away from services to goods. Aggressive monetary and fiscal policy responses helped stoke this demand. However, pandemic lockdowns and labor shortages constrained supply chains and made it difficult for companies to produce these goods to meet demand, pushing up production costs and consumer prices. The war in Ukraine and strict COVID-19 measures in China added to the complexity of obtaining goods, further pressuring prices across the globe.

Home prices and apartment rents also increased after lower-than-normal real estate development in the 2010s.

As the economy reopened, consumers have shifted back to services, including travel and leisure, reshaping the sources but not the level of inflation.

Inflation is back to levels last seen 40 years ago

Inflation is typically measured by the Consumer Price Index (CPI) or the Personal Consumption Expenditures Price Index (PCE), which is the Federal Reserve’s preferred gauge.

While both indexes reflect the price change of a basket of goods and services, the CPI is calculated via surveys of what households are buying, while the PCE is calculated via surveys of what businesses are selling. They also differ in how they are weighted. For example, the CPI is more heavily weighted toward housing and transportation.

Economists often look at “core” measures of each index, which exclude food and energy—commodities that tend to show high volatility in their prices.  

CPI and PCE measure different things

Part of the Federal Reserve’s mandate is to promote price stability, with a longer-term inflation goal of 2%. One tactic the Fed uses to bring inflation down is raising interest rates, which tends to reduce the growth in the money supply. However, it can take time for rate hikes to trickle through the economy and ultimately cool inflation.

Despite a series of rate hikes in 2022, inflation has remained stubbornly high. In September 2022, the core PCE price index increased 5.1% year over year. As of October 2022, Morgan Stanley & Co economists forecast inflation may start to decelerate by the middle of 2023, with core PCE inflation around 2.7% year over year in the fourth quarter of 2023.¹

While there’s no such thing as a perfect inflation hedge, seeking to build portfolios with a diversified mix of assets may help investors to limit the bite of persistently higher prices. Consider:

• Stocks of companies that can pass through higher prices to consumers, which may help preserve (or even potentially improve) margins and profits.
• Exposure to real assets, including commodities, real estate, and infrastructure. Historically, commodities have performed well during periods when inflation has increased. One way to gain broad exposure to real assets is through commodity-focused funds or real estate investment trusts (REITs).
• Treasury Inflation-Protected Securities (TIPS), whose coupon payments adjust with the CPI level. When the CPI rises, so does the bond’s principal value and, thus, its coupon payment (which is based on a fixed interest rate). However, the opposite is also true: If the CPI falls, so does the value of the TIPS principal and its coupon payment. TIPS tend to outperform nominal Treasuries in periods when inflation expectations (called “breakevens”) are rising.

Importantly, make sure any decisions are aligned with individual goals, timelines, and risk tolerance.

1. Morgan Stanley Research, US Economics, “A Sharper Rise, a Steeper Fall for Inflation,” 10/14/22