How does inflation affect investments?
Inflation is a broad and sustained rise in the prices of products and services that people use every day. Its impact is often viewed through the lens of your household budget, as each paycheck purchases fewer of the same items it once did. But inflation can also affect the normal functioning of the economy and investment portfolios. We cover some of the effects of inflation in light of the recent spike.
What is causing inflation?
A sustained rise in prices can be sparked by any number of events. Economists typically classify inflation into two broad categories:
- Demand-pull inflation—When the availability of an item is limited and people want it, the price of that item will usually rise. This happens because people are willing to pay more for that item and because the manufacturers of that item know they can charge more for it.
- Cost-push inflation—In this case, the rising cost of doing business—increases in the price of raw materials and/or labor, for example—means that companies have to pass along price increases to their customers to remain profitable.
Is inflation always bad?
A mild level of inflation is actually healthy for an economy and the financial markets. When consumers expect that prices will rise in the future, they’re more likely to make purchasing decisions today rather than postpone them. That steady source of consumer demand leads retailers to restock their shelves and manufacturers to keep factories humming, and employers are more likely to maintain or add to jobs as a result. It’s a virtuous cycle that winds up boosting economic growth and providing a tailwind for financial markets.
Mild inflation is also a potent preventative against deflation. As the name suggests, deflation is steadily declining prices and an inflation rate of less than 0%. When this occurs, all aspects of the virtuous cycle reverse: Consumers postpone purchases because they expect items to be cheaper in the future, retailers have less incentive to stock their shelves, and manufacturers have less reason to produce. Less consumer demand means less need for workers, so unemployment can rise. Once in play, these negative forces can be hard to stop.
The most well-known episode of deflation is the Great Depression, when prices fell as much as 10.3% for four straight years beginning in 1930. Economic output plummeted and unemployment soared. Deflation has been rare since that time, although it briefly resurfaced in 2009 during what came to be known as the Great Recession. (Europe contended with low or negative inflation rates for several years, and Japan has struggled with deflation since the mid-1990s.)
What’s an acceptable level of inflation? The U.S. Federal Reserve’s (Fed’s) stated inflation target is 2% over the longer run, which it believes is most consistent with the bank’s mandate for maximum employment and price stability. Since 2010, inflation has kept close to that level, fluctuating within half a percentage point on either side of 2% in 9 out of 12 years.¹
How does inflation affect the economy?
As we’ve shown, mild levels of inflation can be healthy for an economy, while negative rates of inflation can damage economic output, however, higher levels of inflation—north of 2%, for example—can also have unwelcome effects.
- Higher cost of borrowing—The primary way the Fed tries to rein in inflation is by raising the short-term interest rate that banks use to borrow money. As base lending rates become more expensive and banks pass these higher rates through to borrowers, demand for loans slows. Meanwhile, interest rates on longer-term debt rise as investors demand a higher yield to compensate for inflation risk. Higher rates across the maturity spectrum result in higher borrowing costs for mortgages, car loans, adjustable-rate loans, and other debt—all of which has a chilling effect on economic activity.
- Business uncertainty—Inflation is typically reduced to a single statistic such as the Consumer Price Index, but an average inflation rate masks the hundreds of individual prices of items that comprise the index, many of which may be rising at vastly different rates. Inflation’s impact on any one business will vary based on that business’s reliance on specific input costs; for example, airlines are more sensitive to fuel prices than, say, florists. What’s more, not all businesses are able to pass on rising input costs to their customers without putting themselves at a competitive disadvantage in the short term if rival companies are better insulated from price moves (using the airlines example again, differences in fuel hedging costs have been a major factor in the past). The complexity of this mosaic creates business uncertainty that can lead to delayed investment and an overall weakening of economic output.
- Changing consumer preferences—Prolonged inflationary episodes can prompt what economists call the substitution effect, often resulting in lasting changes to the economy. For example, when gas prices rose in the 1970s, sales of smaller, more fuel-efficient import autos soared. Fuel efficiency and smaller cars have been with us ever since. Today’s spike in gas prices is fueling a similar shift to electric vehicles that may endure long after the inflation subsides.
How does today's inflation compare with past episodes?
The most notorious bout of inflation in the U.S. postwar period occurred during the 1970s. Then, like today, sharply higher energy costs and geopolitical tensions were key ingredients that aggravated already rising rates of inflation in the United States.
However, there are more differences than similarities between the two periods. Crucially, central bankers at the 1970s Fed underestimated the Fed’s ability to curb inflation, believing that the cost-push inflation of the time was beyond the influence of monetary policy. Fed Chair Paul Volcker, appointed in 1979 to help combat inflation, took a different approach, raising the federal funds rate to a high of 19% in 1981. The ensuing recession was one of the severest since the Great Depression and successfully tamed the runaway inflation of the previous decade. Since that time, the Fed has been much quicker to act against the threat of rising prices.
Another significant difference between then and now is the role technology plays in today’s economy. Technology naturally combats inflationary pressures in numerous ways; for example, by reducing reliance on human labor, by increasing productivity, and through the price transparency of many digital platforms. These features have become pervasive in our economy, whereas in 1969 there were only 16 information technology companies listed in the S&P 500 Index.
Finally, another difference between today’s inflation and that of the 1970s is that today’s inflation rate has—so far—not approached the intensity or duration of the previous period.
Today's inflation hasn't surpassed the peak of the 1970s
Source: Federal Reserve Bank of St. Louis, May 2022.
How does inflation affect rate of return?
Rapidly rising inflation can be a negative for both stocks and bonds. Typically, bonds are issued with fixed rates of interest, so rising inflation reduces the purchasing power of those fixed interest rates. The longer the rate is locked in—with a 30-year bond, for example—the more sensitive a bond’s price is to a change in inflation. With stock prices, inflation’s effect is different but no less negative. Rising prices create uncertainty, making it difficult for investors to assess the value of a company. Higher input costs can also reduce profitability for companies that are unable to efficiently pass those costs on to customers and can lead to lower consumer demand overall.
There are a number of investments that offer a buffer against inflation.
- Adjustable rate bonds—Treasury Inflation-Protected Securities, floating-rate notes, and Series I savings bonds are all income-generating securities specifically designed to help protect your purchasing power from rising inflation. Unlike fixed-rate securities, they feature interest-rate payments that adjust in line with inflation.
- Commodities and precious metals—Investors have historically turned to commodities such as oil and precious metals in times of inflation because these assets tend to rise in value when inflation is accelerating, although the correlation between these assets and inflation may be lower than many investors realize.
- Real assets—Real estate, infrastructure, and other long-dated physical assets may be considered hedges against inflation because their value doesn’t typically fluctuate with either the stock or bond market. Instead, their value is measured over much longer timeframes. Real assets may also create income-generating potential (e.g., from rental income or user fees) that can adjust higher as inflation rises.
Regardless of your financial situation, a sudden rise in inflation is a great reason to talk to your financial professional. Together, you can review your investments to determine whether you’re taking the appropriate level of inflation protection for the long term.
1. Federal Reserve, 2022.
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