Economics is often called the “dismal science” in part because of its poor track record at making predictions. Perhaps the biggest reason for this is the difficulty in determining whether something is a new and lasting trend or a temporary event. This has been the case for inflation forecasts not only over the past two years but since at least the global financial crisis in 2008. What’s different this time is that rapid inflation is rattling markets and consumers alike. How should investors adjust to a world of rising prices for the first time in decades?
A recent Consumer Price Index (CPI) showed that headline inflation grew by 6.8% in November compared to a year earlier and 4.9% when food and energy costs are excluded. Nearly all components of the index contributed to higher prices, including the cost of energy, cars, and meat. Other measures, such as Producer Price Inflation (PPI) which measures the prices of sellers, have reached the highest level in recent decades as well.
Chart: Producer Price Inflation (PPI) has jumped to over 9.6% compared to a year ago.
Sources: Clearnomics, Bureau of Labor Statistics
For many, including the Fed, the defining word for inflation has been, until recently, “transitory.” Unfortunately, this has two interpretations. Transitory can be taken to mean “short-lived,” i.e., lasting only a few months or quarters, or “temporary,” meaning that the effects are due to a one-time event and will eventually fade. And while these definitions are related, they have different implications for the global economy.
There are a couple of points of irony here. The first is that the Fed’s biggest historical success is arguably its handling of the 1970s and early 1980s stagflationary period. By using its interest rate tools, the Fed was able to control inflation, although with recessionary side effects.
The second is that the inflation pressures that many feared following the 2008 financial crisis never materialized. There are a number of reasons for this including the deflationary effects of technology and globalization, which make goods more cheaply available, in addition to more arcane details such as the Fed paying banks interest on excess reserves, which increased the incentive to keep money parked at the central bank rather than lending it into the system.
Whatever the reasons, this time is different. While the long-term deflationary forces are still here, they seem to be overpowered by the near-term effects of the pandemic, supply chain disruptions, excess demand for goods and services, and rising energy prices. This is making it difficult to predict exactly when inflation might subside. And, even when it does, it may remain above historical averages, especially when compared to recent history.
Still, unless the underlying economy were to fundamentally change, it is the case that these effects are “temporary” in nature. This doesn’t necessarily mean that they will fade quickly. But, like the old quote puts it, “if something cannot go on forever, it will stop.”
Where does that leave consumers and investors? Rising inflation has already soured the mood among households with near-term inflation expectations jumping. However, consumers are still spending and household balance sheets are still in a strong position. Unlike the 1970s when the economy was contracting and the job market was shrinking, inflation today is rising alongside a robust economic expansion, which includes decreases in unemployment and increases in wages.
For investors, it continues to be important to stay diversified and to hold assets that can adapt to evolving inflationary environments. Many asset classes that investors already own have these properties, including stocks and real estate, to name but a couple. Large cap companies, for instance, tend to have pricing power and can therefore adapt and are less impacted by inflation over time. All investments carry risk, even if they help decrease potential exposure to evolving inflationary environments.
If any asset class is especially vulnerable in these periods, it’s plain cash. Rising prices erode the purchasing power of cash holdings, underscoring the importance of investing in appropriately diversified portfolios for both return and income.
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