Why protect yourself from inflation using equity ETFs?
James Bullard on monetary policy
James Bullard, President and CEO of the Federal Reserve Bank of St. Louis, discussed a paper by Dr. Kevin Sheedy (assistant professor of economics at the London School of Economics) titled “Debt and Incomplete Financial Markets : A Case for Nominal GDP Targeting” at an event organized by the Brookings Institute in Washington DC.
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What are nominal and real GDP?
The nominal gross domestic product (nominal GDP) of an area for a period (usually a year) is the market value of all final goods and services produced in that area during the period. For example, when we say the GDP of the USA was $15.7 trillion in 2012, we’re saying that the USA produced $15.7 trillion worth of final goods and services in 2012.
While nominal GDP takes into account the current market prices of goods and services produced, real GDP adjusts for inflation, taking into account base year prices.
Let’s assume that a country produced just one product and sold 1,000 units of the same product in 2000 for $5 each. In 2005, the country sold 1,200 units of the product, but the per-unit price rose to $6 due inflation.
In the above case, the nominal GDP for 2005 will be $7,200, while the real GDP will be $6,000.
“Inflation” refers to increases in price level. Inflation affects prices for goods and services—and so it affects our lives. Let’s say a person earns $2,000 a month. They spend $1,200 on other living expenses. So they’re left with $800 in savings at the end of the month. If their expenses rise 10% in the next few months while their income remains the same, their savings will fall to $680—a 15% decline!
Rising inflation also affects corporations. For example, a rise in oil prices affects operating performance for airline companies such as Delta Airlines (DAL). An increase in gasoline prices affects car sales, in turn affecting companies like General Motors Company (GM) and Ford Motor Company (F).
To partially protect themselves from inflation, investors can invest in ETFs such as the iShares Barclays Treasury Inflation Protected Securities Fund (TIP), iBoxx 3-Year Target Duration TIPS Index Fund (TDTT), and Vanguard Short-Term Inflation-Protected Securities ETF (VTIP). These funds invest in securities that offer inflation-protected returns.
To learn more about why inflation is so important for central bankers and to understand the theme of the underlying paper and the speech Bullard gave, read on to Part 2 of this series.