Just as peeling an onion can bring tears to your eyes, paying higher prices at the grocery store can be equally uncomfortable. However, the analogy goes deeper. Like an onion, inflation has multiple layers that reveal its complexities.

Let’s peel back these layers to understand what drives inflation and how it influences the Federal Reserve’s (Fed’s) policy decisions and investor portfolios.

Three Layers of Inflation

John C. Williams, president and CEO of the Federal Reserve Bank of New York, has compared inflation to an onion with the three layers depicted in Figure 1.

The Outer Layer

The outer layer of the inflation onion includes globally traded commodities like food, energy and raw materials, making it the most volatile layer.

During the pandemic, these prices soared because of supply and demand imbalances. Similarly, the Russia/Ukraine war drove energy and grain prices higher, forcing producers to pass on price hikes to consumers. Now, tariffs threaten this layer.

The Middle Layer

Core goods, such as appliances, furniture and cars (but not food and energy), comprise the middle layer of the inflation onion. Short-term inflation expectations, import prices and tariffs typically influence core goods inflation.

Tariffs will likely have the most immediate impact on the outer and middle layers of the inflation onion, potentially pushing consumer prices higher. Any resulting increase in the core inflation rate could force the Fed to raise interest rates. However, if tariffs also trigger a notable slowdown in economic growth, the Fed may find itself in a conundrum.

Some economists believe fiscal stimulus, tax and regulation cuts, increased domestic energy production and onshoring could offset the effects of tariffs.

The Inner Layer

This layer consists of core services, which are the trickiest to control because they typically change slowly. The inner layer includes shelter (rent, owners’ equivalent rent and lodging) and services like education and barber visits. Core services minus housing services defines the Fed’s “super core” inflation measure, which is most sensitive to wage growth.

Some economists isolate housing services from inflation equations because housing prices have diverged from other goods and services prices in recent years. For example, core goods and services prices generally moderated post-pandemic, while housing costs have remained stubbornly elevated, as Figure 2 shows.

Putting the Onion in Context

Because economic data is backward-looking, the Fed must implement policy based on its best inflation forecast. Therefore, policymakers are less concerned about one-off events than persistent inflation trends. In general, prices comprising the core of the onion — which the Fed finds most useful — are less likely to change dramatically.

For example, a jump in oil prices on the outermost layer of the inflation onion may be less concerning than material changes in transportation services. A notable rise in core services, largely due to its strong link to wage growth, may signal mounting inflationary pressures.

Tariffs Could Change the Game

Responses to President Donald Trump’s tariff policy from our global trading partners represent a wildcard for the inflation backdrop. Depending on the specific tariff’s structure and duration, producers could either absorb the additional cost or pass along higher prices to consumers.

Shifting policy and tariffs could affect commodities and goods prices, creating an uptick in inflation. Eventually, this could even affect the inner layer of the onion, particularly if wage pressures build.

However, the extent and persistence of rising prices are up for debate. Is Trump using tariffs to negotiate better trade deals and other agreements for the U.S.? Or are tariffs part of his administration’s long-term policies?

Unlike the trade wars of Trump’s first term, today’s tariffs may likely affect everything from gaming consoles to toys to shoes, hitting squarely in the middle layer of the onion. The inflation climate is materially different today than during Trump’s first term when core inflation was consistently at or near the Fed’s 2% goal.

What Drives Inflation?

A Complex Web of Supply and Demand Forces

Following the Global Financial Crisis, inflation lingered at historically low levels. This stopped in 2021 when inflation soared to multidecade highs amid pandemic-related effects. Inflation has since moderated but has remained elevated relative to pre-2021 levels and the Fed’s target.

Several forces can pressure prices and drive the inflation rate higher, including:

• Supply issues. Supply chain bottlenecks, raw material shortages and labour shortages can trigger “cost-push” inflation.
• Demand surges. Prices rise when demand for goods or services outstrips supply or production capacity. We’ve recently seen this in the housing market, where strong demand and limited supply have contributed to rising prices.
• Government spending. When the government prints money to finance its spending, the nation’s money supply grows. And when more money goes into circulation, the dollar’s value declines, causing prices to rise.
• Consumer expectations. When consumers expect higher inflation in the future, their behaviour can make it a reality. For example, employees can demand higher wages, prompting businesses to raise prices.

From the Fed to You: Avoiding the Tears of the Inflation Onion

We all feel the pinch of higher prices at the grocery store, but higher prices have more profound consequences over time. Higher inflation ultimately erodes your purchasing power. If prices increase and your income doesn’t rise at the same pace, your dollars won’t go as far.

Inflation can also erode your investment returns. “Inflation risk” refers to the possibility that your investment performance won’t keep up with the pace of inflation. If you’re retired or nearing retirement, this is a critical consideration for meeting your income goals.

No Asset Class Is Immune to Inflation, but Some Are Designed to Help

No investment asset class is wholly protected from inflation risk, but fixed-income securities may be more vulnerable. For example, when inflation rises, interest rates typically increase, too. But rising rates make existing bonds with lower rates less attractive, and their prices decline.

Similarly, inflation erodes the purchasing power of a bond’s fixed interest payment. Consider a bond that pays $500 in interest annually. A persistently high or steadily rising inflation rate will stifle the future buying power of the bond’s annual interest payment.

However, some fixed-income securities offer better inflation-fighting potential, underscoring the possible appeal of holding a diversified bond portfolio. For example, Treasury inflation-protected securities (TIPs) are designed to protect investors against inflation.

The face, or principal, value of TIPS adjusts along with the inflation rate. So, when inflation rises, TIPS’ values also rise (and when inflation drops, TIPS’ values decline). Moreover, when inflation rises, the interest payments from TIPS also increase because those payments are based on the adjusted principal value.

Diversified Assets Are Your Onion Goggles

As Figure 3 illustrates, a diversified portfolio of stocks, bonds and real assets can help curtail the negative effects of inflation. Over time, many asset classes have historically delivered returns that outpaced inflation.

Other assets, such as real estate, have a built-in resilience to inflation. Real estate investment trusts (REITs), for example, generate interest income from rents. They deliver the potential to increase in value because property costs and rent prices tend to increase over time and during inflationary periods.

Our favoured strategy is to work with a financial professional to maintain a diversified investment portfolio. Assembling an asset mix attuned to your goals, risk tolerance and investment horizon may help preserve long-term purchasing power.

Stay Vigilant About Sticky Inflation

Unpeeling the layers of the inflation onion illustrates how the Fed dissects inflation and steers policy. Given today’s uncertainty surrounding tariffs and global trade, a resurgence in inflation remains a possibility.

In the meantime, ensuring that your investment portfolio is broadly diversified is likely a prudent strategy.

By Joyce Huang, Senior Client Portfolio Manager of Global Fixed Income

The post How layers of inflation affect consumer prices appeared first on AdviserVoice.

Balaji Venkataraman

In the current economic climate, many investors view cash as a safe harbour. Yet as interest rates approach a peak, the hidden risks of relying too heavily on cash have come into sharper focus.

Cash is often touted as the safest investment, particularly in times of economic uncertainty. The logic is simple: cash doesn’t fluctuate in value like stocks or bonds, and it provides liquidity that can be deployed quickly when opportunities arise.

However, cash may not be the risk-free investment it appears to be or once was, and investors would be wise to consider a more diversified approach to managing portfolio risk.

Holding cash comes with significant downsides, especially in a low-interest-rate environment. As interest rates decline, the returns on cash equivalents – such as money market funds, Treasury bills, and certificates of deposit (CDs) – also drop. This can erode purchasing power over time, particularly when inflation is factored in.

The current economic outlook suggests that the central banks such as the Federal Reserve in the US may cut interest rates in the near future, which would further reduce the yield on cash holdings. While the Reserve Bank of Australia may be further away from a rate cut, it is most likely that the next move will be down. Investors who are overly reliant on cash could find themselves facing reinvestment risk—the possibility of being unable to reinvest at the same or higher returns, thereby reducing overall income. This risk is particularly pronounced in a falling interest rate environment, where the returns on cash equivalents will likely follow the downward trajectory of the Fed funds rate.

Another often overlooked risk is the opportunity cost of holding large cash reserves.

While cash provides liquidity and safety, it also means missing out on potential gains from other asset classes. Bonds, for example, can offer attractive yields, particularly in the current high-interest environment. As interest rates begin to fall, the prices of bonds typically rise, providing capital appreciation in addition to yield. This dual benefit is something that cash simply cannot offer.

Investors who remain too heavily weighted in cash risk missing out on these opportunities. As inflation continues to erode the real value of cash, the purchasing power of these holdings diminishes over time. In contrast, a well-diversified portfolio that includes bonds and other income-generating assets can help mitigate these risks while providing the potential for growth.

Given the risks associated with a cash-heavy investment strategy, diversification becomes crucial. While it’s important to maintain some level of liquidity, particularly for short-term needs, investors should also consider allocating a portion of their portfolio to bonds and other income-generating assets. Investment-grade bonds, in particular, offer an attractive combination of yield and capital appreciation potential, especially as interest rates begin to decline.

Bonds with longer durations are particularly appealing in this environment, as they tend to experience greater price appreciation when interest rates fall. This can help offset the lower yields that cash investments will likely generate in a declining interest rate environment. By locking in today’s higher yields, investors can secure a steady stream of income while positioning their portfolios for potential capital gains.

While cash has its place in a well-rounded investment strategy, relying too heavily on it can expose investors to significant risks, particularly in a low-interest-rate environment. The key to managing these risks lies in diversification—balancing the safety and liquidity of cash with the yield and growth potential of bonds and other income-generating assets. By doing so, investors can better position themselves to weather economic uncertainty while still pursuing long-term growth.

By Balaji Venkataraman, client portfolio manager and Joyce Huang, senior client portfolio manager.

The post The risk of cash in a low-interest environment appeared first on AdviserVoice.