Inflation is coming. Or is it? The alarm bell's been ringing since last year's massive stimulus packages were announced. But are higher prices a foregone conclusion? Not necessarily. They depend on many factors. Even so, that might be the wrong question to ask. Instead, investors should be wondering: If inflation ticks up, what does that mean for my wealth?
Why the fuss?
Inflation is the rise in prices. Or stated another way—it's the loss of spending power. Inflation has several causes. We group them into two broad buckets for simplicity's sake: supply/demand imbalances and the amount of money in circulation.
Supply/demand imbalances cause inflation when there is high demand for little supply. Think of the hot toy—a Cabbage Patch Kid—during the holiday season. The demand for that Cabbage Patch Kid was sky-high during the peak shopping season, yet supply was limited. So, what did enterprising individuals or independent retailers do? They jacked up the price of their inventory, of course! While that's inflation, it's short-lived and particular to that toy.
More worrisome inflation has broader implications. Take the price of oil. When supply is limited, oil prices increase. Imbalances can arise when demand is high—during a colder than normal winter, for instance—or during a supply disruption—such as a hacker interrupting the east coast pipeline. This imbalance usually takes a while to correct. Hence, the inflation is less transitory than it was for a holiday toy. And because consumers are paying more for heating oil or gasoline, they have less to spend on other goods and services. Thus, energy inflation can cause a ripple effect on different parts of the economy.
However, the price change of one good or service—like the hot toy or oil—does not indicate sustained inflation. To have a widespread, lasting impact, prices need to change for a basket of goods and services produced in the economy. That is directly influenced by the amount of money in circulation, which is a major reason behind today's concerns.
Following the US government's stimulus packages and other measures to ease pandemic-induced economic woes, the supply of money in the US grew by the highest percentage since WWII. The massive increase in 2020 may seem alarming, but the unprecedented stimulus to stave off the COVID recession should normalize once the pandemic is under control, and the money supply should fall back to more normal levels.
When the money supply grows but the speed of money exchange and the output of goods and services do not, an increase in prices ensues.
Are rising prices certain?
Despite warnings abound, rising inflation is not a guarantee. In fact, many called for high rates of inflation coming out of the Global Financial Crisis of 2008-2009, which never materialized. That said, given the sheer magnitude of the COVID-19 stimulus, inflation does appear likely.
Reported inflation has already been moving higher since it is measured relative to the same period a year ago. When the economy was sheltering in place last year, consumer prices (as measured by the consumer price index or CPI) fell to their lowest level since 2015, registering a 0.1% change1. However, the latest reading1 of 2.6% is back to pre-COVID levels. Since the economy continues its reopening efforts, an uptick in inflation compared to last year could—and likely will—occur.
In addition, consumers who spent less during the pandemic or those who received stimulus checks may be apt to spend more this year, increasing the supply of money in circulation and putting upward pressure on prices. Will the Federal Reserve (Fed) take action to halt the upswing?
The Fed revised how it looks at inflation and when it feels the need to raise interest rates. Instead of targeting 2% directly, it will aim for "a flexible form of average inflation targeting" 2 and allow inflation to fall above or below the 2% mark for a period.
Since inflation has not meaningfully reached above 2% since 20113, it seems reasonable that the Fed will allow inflation to be higher than 2% for a while before raising interest rates. (Higher rates tend to correlate with fewer loans, which restricts the speed at which money changes hands.) How can moderately higher inflation impact your wealth?
Inflation and your wealth?
Higher inflation can increase the cost of living—everything from groceries to rents—which reduces the spending power of your money. To those individuals living off a fixed budget—like many in retirement—significantly higher prices are concerning.
But inflation can be good for holders of assets whose values rise faster than inflation. Real assets—like real estate or commodities—are oft-cited examples (see the returns in the “Rising Inflation” column below).
But over the long term (i.e., last 50 years)—inflationary periods included—investors holding commodities fared worse than those holding stocks (see the returns in the “Total Period” column below). Bondholders were also not rewarded.
How do stocks perform relative to bonds?
Bond investors receive two sources of return—a coupon and the principal at maturity. A coupon is a cash flow that happens in the future. So, when inflation—or the fear of future inflation—goes up, those future cash flows become worth less. That's because if the market believes that there is higher inflation on the horizon, bond yields will rise. Bond prices will fall to compensate for the loss of the purchasing power of future cash flows.
Stock investors get paid (assuming they sell) when a security's price rises. Stock prices tend to be a function of a company's profits. Rising inflation can cause earnings to decline if input costs increase or revenues decrease as consumers purchase fewer goods. If a company needs to borrow money, its borrowing costs may also be higher during inflationary periods.
Some companies, though, can combat the effects of rising input costs by passing them along to consumers; they have pricing power. So, after the initial shock of inflation, quality companies can often overcome the impact on their earnings.
But the level of inflation matters. Analysis of the S&P 500 reveals that real returns are greatest when inflation is between 2%-3%. Some market analysts are expecting inflation to be about 3.5% over the next 12 months, but to fall between 2-3% each year after for the next 10 years.4
What about holding cash? The value of cash also decreases over time as inflation takes hold. That is because a dollar today can buy more than a dollar tomorrow if prices rise.
Don't be short-sighted
Inflation may be on the rise. Unfortunately, it's hard to predict when and by how much. So, buying an asset that does well only in inflationary environments often leaves investors worse off in the long run. Instead, investors who hold assets that perform well over the long term—in various conditions—can potentially navigate higher price environments without sacrificing overall returns.
Stocks have historically been among the best at accomplishing that goal. If you are worried about a period of sustained higher prices, review your asset allocation to see if it makes sense for the short-term environment and your long-term wealth plan.