Inflation - The Big Picture

Inflation has been the word of the year in economic news, and for a good reason.  Given the robust economic recovery following the pandemic, increases in price levels were inevitable.  But, as with most news in 2021, it’s challenging to find a consensus on what this means for investors.  So before delving into such discussions, it’s important to understand inflation and the potential impact on capital markets.

Inflation is a persistent rise in the general price level of goods and services in an economy.  This is not a temporary jump in prices nor a rise in price level of a single good.  Inflation is an economy-wide phenomenon.  If your favorite box of cereal temporarily rises in price, you have my deepest sympathy, but that would not indicate rising inflation.

Rising inflation erodes the purchasing power of a currency, which is an effect of too many dollars chasing too few goods/services.  Inflation affects consumers and increases input prices for corporations which lower profitability.  When rises in inflation are expected, corporations can pass through input price increases to consumers, and consumers have proven to quickly acclimate to a new pricing environment; however, inflation unexpectedly rising above target has proven to cause bigger concerns for the economy and stock market.

To further understand how inflation affects capital markets, we must also understand the Federal Reserve and the policy tools used to combat inflation.  The Federal Reserve was established in 1913 as the “lender of last resort.” They have what is known as a “dual mandate.”  As stated by the Federal Reserve Bank of Chicago, “Our two main goals of price stability and maximum sustainable employment are known collectively as the dual mandate.”  Understanding both mandates in conjunction with one another is critical, but for the sake of the inflation discussion, let’s focus on the price stability mandate. 

In the past, the Fed has targeted an inflation rate of 2%.  Therefore, an inflation rate far below 2% is a sign of weak economic growth, and inflation at 2% is a sign of healthy economic growth.  While economic growth is clearly positive, an overheating economy can result in an unsustainable increase in inflation which puts the Fed’s price stability mandate at risk.  When the inflation rate is not running on target, the Fed has three policy tools to stabilize prices: changing the discount rate, changing reserve requirements, and open market operations.  We will focus on the first tool: changing the discount rate.

When the economy is slowing, inflation is typically running below the Fed’s target.  Therefore, to stimulate growth, the Fed will increase the money supply by decreasing interest rates and increasing the amount of reserves in the banking system.  This will encourage more borrowing and increase economic activity, which eventually leads to an increase in prices.

If inflation is running above target, the Fed may need to take action to fulfill its mandate to stabilize prices by slowing economic growth. Therefore, they will decrease the money supply by increasing interest rates and decreasing banking system reserves.  This will lead to a reduction in borrowing and economic activity, which will eventually reduce inflation.

So, inflation at or around the Fed’s target is a good thing.  It is a natural product of a healthy, growing economy.  That growth drives consumer activity, corporate profits, and continued development.  It will also benefit borrowers with fixed-rate loans because dollars used to repay the loans are worth less than dollars originally borrowed.  Only when inflation persistently runs above or below the Fed target, it will start to impact capital markets. 

Inflationary impacts on fixed income assets are relatively straightforward.  It erodes purchasing power of interest payments and the principal of bonds.  Bond prices move inversely to interest rates.  Therefore, as the Fed increases interest rates to stabilize prices, bond prices fall.  There are two fixed-income securities that protect from inflation: inflation-linked bonds and floating-rate bonds.

Equities and inflation have had a much more complicated relationship.  As previously stated, expected inflation over a long-term period is not a problem for corporations due to their ability to pass through input costs to consumers.  Therefore, equities have proved to be a good long-term investment in moderate inflationary environments.  However, equity returns have a negative correlation to inflation over a short horizon.  This effect is more pronounced in growth stocks due to their valuation’s dependency on future earnings.  As interest rates rise, those future earnings are discounted at a higher rate, resulting in a lower present value.

Now that we understand how inflation can potentially impact capital markets, let’s revisit the current economic environment.  The Federal Reserve unleashed an arsenal of policy tools in late March 2020 to bring the economy back to life from the pandemic-induced coma.  This and unprecedented fiscal stimulus led to the quickest recovery from the shortest recession in history.  Although there are still looming concerns of the Delta variant, the Fed has done its job to stimulate growth and catalyze the economic recovery.  After a full-stop in several sectors of the economy and massive fiscal stimulus, demand was inevitably going to increase, which, of course, would lead to price acceleration, which supply-side issues have further exacerbated. 

The Fed has remained adamant that the current rise in inflation is “transitory.”  Their position is that demand will eventually decline back to a post-pandemic normal, and supply chain issues will correct. This is critical to consider, particularly when coupled with the fact that the maximum sustainable employment part of the dual mandate is far from being accomplished and the heightened uncertainty presented by the Delta variant.  If current inflation is not temporary, the Fed would be more likely to make policy adjustments, and markets will react to the new economic environment. 

At the moment, market participants seem to agree with the Fed’s transitory stance.  Interest rates have stabilized, and the stock market continues to reach new all-time highs; however, this is a fluid situation that the Fed, investors, and your advisor will continue to monitor as 2021 unfolds.  We encourage clients to reach out to their advisor with any questions on this or other topics.