Inflation is the increase in prices for goods and services during a period. It is measured by the Bureau of Labor Statistics (BLS) and reflected in the Consumer Price Index or CPI. In the U.S., average inflation rates were 3.27% between 1897 and 2022. Moderate inflation has existed throughout the natural economy of over 100 years. In fact, it is necessary for economic growth.
So, we can’t make a blanket statement that inflation is bad. There’s a little more to it. We will explore more about inflation and world events and discover what it means for our investments.
What causes inflation?
Several factors may be responsible for inflation: Supply disruptions, easy monetary policy by the Federal Reserve, federal government spending, and increasing energy consumption to name a few. All of those can lead to an inflationary environment.
Supply Side Inflation
Supply side inflation occurs when insufficient supplies are available to satisfy demand. This shortfall causes price increases. In recent times, pandemic-induced short supply was accompanied by substantial inflationary pressure on demand items. In some cases, the limited supplies of materials slowed building. The Federal Reserve has found 40% of the higher price spikes from 2019 onwards to 2021 were a consequence of supply-side issues.
Demand Side Inflation
Inflation is also demand based. If the demand is increasing, it may cause the prices to increase if the supply keeps level. A recent report found that 60% of the increase in prices between 2019-2023 is attributed to demand-side factors. During the Pandemic, demand-side inflation was partially accelerated by easy monetary policies.
What’s happening with inflation rates right now?
In the late 70s and early 80s, the U.S. economy experienced persistently high inflation resulting, in part, to a major energy shortage during the Arab Oil Embargo. In response to this period of high inflation, the U.S. Federal Reserve Bank increased interest rates significantly. Despite the risks of lower economic growth and potential for recession, the Fed viewed a drastic reduction in consumer purchasing power as a greater threat.
Many of my clients, having experienced high inflation, are understandably nervous about this current period of higher prices. They often share experiences of having a fixed rate mortgage of 16% and bank CDs for 14%. For comparison, as of the end of 2022, 30 year fixed rate mortgage interest rates are around 6.5% and 12 month CDs are about 4%.
In October 2022, prices of goods and services increased by 7.7% compared with the year before according to the BLS Consumer Price Index. As inflation rises, central banks around the world are adopting tighter monetary policy.
As in the past, inflation measures taken by the Fed are impacting the financial markets. This can be seen from increased volatility in both the stock and bond markets. I’ve heard it said that “history doesn’t repeat itself, but it rhymes.”
If you look back at significant world events and their impact on financial markets, you will see wars, pandemics, natural disasters, and financial crises. What is going on today isn’t necessarily new, however, that doesn’t minimize the signficance of the events.
Inflation & The Federal Reserve
In late February 2020, inflation was the least of our concerns. It became clear Covid-19 would have a disasterous impact on the global economy. Central banks around the world flooded the system with cash by slashing interest rates to zero. Additionally, governments passed aggressive stimulus plans to stave off a severe recession and possibility of a second Great Depression. Yes, the prospects were that grim.
Oil prices collapsed due to the drop in demand. At one point, there was so much supply that oil had to be stored on ships and at other facilities. For a time, suppliers couldn’t even sell their oil. They had to pay to have people take delivery of oil. Stop and consider how significant that is. This resulted in a bizarre price event that turned the price of a barrel of oil negative! According to Daniel Yergin, author of The New Map,
“on April 20, 2020…the lowest price ever recorded for a barrel of oil – minus $37.63.”
These price distortions didn’t last long, and as the global lockdowns began to ease, people got back into their cars. Demand increased and has been increasing ever since.
By late 2021, the booming economic recovery in the U.S. was evident by record low unemployment, record high stock market, and record high real estate values. Our economy and others around the world simply got too hot to handle.
Unsuprisingly, inflation started rearing its head. In 2022, the Federal Reserve has begun aggressively raising rates. We’ve seen a steep rise in the 10 year treasury now around 3.6%. Fixed rate mortgages have followed suit with average 30 year rates around 6.5%.
Central banks around the world no longer fear recession or depression. They fear inflation and that’s why rates are heading up.
Inflation And The Covid Surge In China
While Covid numbers have been dropping considerably in the U.S. and the West, China is back to the lockdowns. China has one of the biggest economies on the planet and it’s grinding to a halt.
China was hit hard from the initial outbreak in late 2019 and early 2020. They were returning to normal as we were shutting down. However, due to their refusal to use the MRNA vaccines developed in the west, their population is being hit even harder now by the Covid variants.
China has been a huge driver of economic growth for the past two decades. With export levels dropping, this is adding fuel to the inflation fire and raising concerns about price increases in the U.S. At the time of this writing, there is little indication the Covid-19 numbers are improving there. In fact, some economists are reducing their GDP forecasts for China.
While the Chinese economy is usually the main focus, some analysts are keeping an eye on the growing frustration among its citizens. In the U.S., we use the term “lockdown” rather loosely. We never really had lockdowns here. We were free to move around with certain restrictions.
In China, they lock people inside their apartment buidlings by installing fencing so people can’t get out. This is happening in China’s biggest cities and there are growing reports of discontent among residents with unprecedented protests.
It remains to be seen how far the Chinese authorities are willing to go to maintain their “Zero Covid” policy. It’s also unknown how long the Chinese people will put up with it.
Russia’s Invasion of Ukraine
Markets don’t like uncertainty and Putin is the ultimate wildcard. While Ukraine is providing stiff resistance and successfully defending their country, some fear Putin could, in desperation, resort to more extreme measures like chemical or nuclear weapons.
In addition to a major war raging in Europe, uprecedented economic sanctions have been levied against Russia. These sanctions will have negative impacts on the West. Examples include rising commodity prices for consumers (gas & oil) and lost revenue for Western businesses no longer operating in Russia.
Rising Prices and Interest Rates
Governments have an incentive to maintain price stability. Persistently high inflation can have dire consequenses. Rising costs erode the purchasing power of its citizens to purchase goods and services. Raising interest rates is the main tool to combat higher prices.
When a central bank raises interest rates to reduce inflation, it is tightening the money supply. The result is higher costs to borrow money. This leads to a decline in economic activity where inflation and interest rates generally follow a similar pattern.
Bonds and Fixed Income
Bonds typically provide regular interest income at a fixed rate. Higher inflation affect the value of bonds because the current value of those incomes is decreased. That can severely impact retirees on fixed incomes.
As interest rates rise with higher inflation expectations, the value of bonds and bond mutual funds decline. When new bonds come to market, they are priced with prevailing interest rates which are higher than those previous issued.
Bond prices move inverse to interest rates. If rates are going up, the price of bonds typically go down. Much of this depends on whether the bonds are long, intermediate, or short term. The longer the time to maturity, the greater the price change in relation to interest rates.
If you’d like to dive deeper into maturity and duration, you can view my article Bond Mutual Funds for more information. The main take away is that bonds can lose value when rates rise. This is especially the case if rates rise rapidly.
When the stock market perceives diminished economic activity coming in the future due to higher interest rates, growth stocks usually take a big hit. Growth stocks can be expected to outperform the market when rates are low and economic activity is high. Growth stocks can typically be found in the tech sector. In 2022, the tech sector of the stock market has been the worst performer.
Value stocks tend to hold up better when inflation hits. They are not immune from the effects of inflation. However, some value oriented companies tend to do well as inflation rises. They can benefit from higher prices when those costs can be passed through to the consumer.
When borrowing costs rise, the housing market can be impacted by a reduced demand for home purchases. If the the monthly payment increases significantly, that can keep some home buyers on the sidelines. The result is reduced demand.
An existing home owner might not be able to afford the payment when an adjustable rate mortgage (ARM) resets. This might force someone to put their home on the market. On a large scale, this might result in a decline in real estate prices.
However, property owners can charge more rent in an inflationary environment. As rent prices increase, the owner’s cash flow improves making real estate a more attractive investment.
Is inflation bad for investments? Maybe. But maybe not. It really depends on your situation. There’s no doubt inflation expectations are affecting markets. Persistently high inflation hurts our purchasing power. But our inflation expectations also impact our investment decisions.
Now what should you do about it? Unless you’re a day trader, likely nothing. By that I mean, changing your portfolio in the middle of a volatile period like this doesn’t make much sense. Having said that, it can be beneficial to reallocate your porfolio to keep things in balance.
As investors, it is important that we don’t let short term market moves affect our decision making. I know it’s easier said than done, but I’ve seen it work time and time again over the last 20 years.
I like to remind my clients there is never a flashing green light indicating a safe time to invest. There will always be war, pandemics, or other dangers around the proverbial corner. We should expect there will be tough times and be wise enough to know they don’t last forever.
That isn’t to say we should put our heads in the sand and pretend everything is ok. At the same time, we need to be realistic about what we can and can not control.
Inflation won’t last forever. Russia’s war against Ukraine will end. The pandemic will run its course.
Investing with confidence and having the right expections will go a long way toward helping you achieve your goals.