Is inflation back on the radar for investors?

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      By Jason DesLauriers, CFAInvestment Grade Fixed Income Trader, Eaton Vance Management and Brian S. Ellis, CFACalvert Fixed Income Portfolio Manager

      Boston - Investors have been fortunate over the past decade that inflation has receded to a secondary concern in most people's minds. However, with unprecedented fiscal and monetary stimulus, along with an economic rebound from the first half of the year, we believe that inflation has the potential to increase at a much faster rate than we have recently seen.

      We base this assessment on the increase in demand as some areas of the economy have begun to reopen in earnest. Demand-pull inflation — prices rising on specific COVID recovery-related products — combined with cost-push inflation — production costs such as wages and raw materials starting to rise more broadly — should support inflation over the near term.

      Latest inflation readings show acceleration

      The most recent data show that Core Personal Consumption Expenditures (PCE) and the headline Consumer Price Index (CPI) have increased at year-over-year rates of 1.5% and 1.4%, respectively, well off their lows from earlier this year. Certain components of CPI continue to support overall inflation, with food (+3.9%) and medical care services (+4.9%) as some of the largest factors.

      On top of that, used vehicles (+10.3%) had their biggest year-over-year change in a decade, as COVID-related fears of mass transit drove many urbanites to opt for private over public transportation. We expect supply disruptions, which can push prices higher, to remain prevalent as business continue to operate below full capacity.

      However, some major components still weigh on CPI and slow that growth. For example, much of the higher inflation seen in individual components was offset by the decrease in energy prices (-7.7%) over the past year. This bears careful watching, since an eventual reversal in energy prices could trigger an unexpected pop in inflation when transportation starts to recover — and people drive their newly purchased used cars.

      Fed revises inflation targeting policy

      There's another unsurprising factor in our prediction of higher intermediate-term inflation. The US Federal Reserve (Fed) recently announced a revision to its traditional inflation policy — to let inflation run above 2%, essentially targeting 2% average inflation target over the long term.

      The Fed had previously felt that it would be better to raise overnight rates preemptively based on factors like the unemployment rate — rather than to move later and risk a period that significantly overshot its inflation target. With the lack of significant wage inflation since the Global Financial Crisis, the Fed modified its position to adjust to recent economic history.

      Inflation protected securities present trade-offs

      While signs point to increased inflation, it's worth noting that the default reaction to purchase US Treasury Inflation Protected Securities (TIPS) comes with a trade-off: TIPS deliver both inflation protection and, with longer-maturity TIPS, the return profile of a long-duration US Treasury security.

      As inflation increases, overall interest rates typically increase — potentially leaving investors with duration-related losses that can offset any gains from increases in inflation over the short term. Even small increases in interest rates can have a negative effect on the total returns.

      Bottom line: With inflation slowly re-emerging as a threat to fixed income investors, we believe that a wider variety of investments — including floating rate bank loans, short-duration TIPS and other securities offering yield spreads over US Treasurys — deserve consideration as inflation defenses.