Inflation has become a popular topic as a great deal of debate has been devoted to expansionary economic policies and its impact on the price of goods and services. Some pundits argue current fiscal and monetary policy could lead to higher inflation and economic carnage while others accept higher inflation as a function of the economic recovery. Larry Summers, a well-known economic policy official under previous Democratic administrations, has characterized our current macroeconomic policy as irresponsible and warned about its negative consequences on inflation.[1] On the other hand, chairmen of the Federal Reserve, Jerome Powell, has recognized the potential for higher inflation but also affirmed the Federal Reserve maintains the tools to manage any concerning rise beyond expectations[2].
In this blog post we plan provide our perspective on what inflation is, how it relates to our current economic environment, and potential implications on investment assets.
What is inflation?
Inflation is an economic phenomenon related to both the supply and demand for goods and its influence on prices. Economists and investment strategists undergo considerable effort forecasting why inflation and prices will go up or down. Rising inflation can have both positive and negative impacts depending on whether the rise in prices results from demand-side or supply-side pressures. An example of demand-side inflation is when consumer discretionary income increases faster than supply. This creates a situation where you have more demand than supply of goods. During the COVID-19 lockdowns, many economists warmed about supply-side shocks to the economy because government lockdowns would disrupt supply chains and limit access to goods and services.
How does it relate to our current economic environment?
The economy currently has several factors that are expected to push both inflation and economic growth higher.
The Federal government is seeking to drive growth in the economy with stimulus payments, child tax credits and loans. By the end of 2020, government stimulus programs raised personal income to 6.1% [3] and personal savings to 13.5%[4]. It helped improve savings rates and lower debt liabilities for consumers. The combination of pent-up demand from Covid-related lockdowns, rising employment, potential for infrastructure spending and consumers with healthy balance sheets should all have a positive impact on the economy and push inflation higher.
Additionally, the Federal Reserve Bank is committed to supporting the economy through expansionary monetary policy by providing ample liquidity to the market through low interest rate policies and bond purchases. Jerome Powell in his post-FOMC meeting and congressional speeches has reaffirmed the Federal Reserves commitment to these policies over the foreseeable future.
Conversely, we have several structural factors in play to moderate inflation and keep it from running out of control. For the whole post Great Financial Crisis recovery, the Federal Reserve has been trying get inflation back near its mandated 2% but inflation has stayed stubbornly low. Many would attribute this to the deflationary impacts of technology, demographics, and global competition.
Additionally, higher inflation this year has been described as “transitory,” meaning inflation is expected to revert towards its long-term average next year. Inflation seems high compared to last year due to the suppressed data related to government mandated lockdowns.
What are the potential implications of inflation and higher growth on investment assets?
We anticipate the markets are entering into a reflationary period characterized as a period of higher inflation caused by higher growth. The Federal Reserve recently increased its 2021 GDP growth estimate to 6.5%[5], and some believe GDP growth could hit 8% this year[6]. Historically, periods of high GDP growth and rising inflation have been good for equities. Higher growth reflects a healthy consumer and a strong business environment. The fixed income market is already starting to reflect higher growth and inflation expectations with the rise in 10-year treasury yield rate. A rising yield environment could be a drag on fixed income returns.
Ultimately, investors should tread carefully. Any upside surprise in growth beyond expectations could compel yields and inflation to rise faster than expected and force the Federal Reserve to abandon its low-rate policies. This would create a bit of uncertainty and volatility in the market.
Disclosure
Stock investing includes risks, including fluctuating prices and loss of principal.
The economic forecast set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
[1] Davis, Andrew (2021, March 20). Summers Sees ‘Least Responsible’ Fiscal Policy in 40 Years. Retrieved from https://www.bloomberg.com/news/articles/2021-03-20/summers-says-u-s-facing-worst-macroeconomic-policy-in-40-years?sref=0NCA5RSF
[2] Smialek, J. & Rappeport, A. (2021, March 23). Powell Downplays Inflation Risks as Yellen Foreshadows Future Spending. Retrieved from https://www.nytimes.com/2021/03/23/business/economy/powell-yellen-testimony-inflation.html
[3] State Annual Personal Income, 2020 (Preliminary) and State Quarterly Personal Income, 4th Quarter 2020 (2021 Marc1, March 24). Retrieved from https://www.bea.gov/news/2021/state-annual-personal-income-2020-preliminary-and-state-quarterly-personal-income-4th
[4] https://fred.stlouisfed.org/series/PSAVERT
[5] Summary of Economic Projections (2021, March 17). Retrieved from https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20210317.pdf
[6] Rabouin, Dion (2021, March 15). Goldman Sachs predicts U.S. Economy will grow 8% this year. Retrieved from https://www.axios.com/goldman-sachs-us-economy-grow-8-per-cent-2021-eb7e1d84-b6fa-483a-9e19-37a7faddadc0.html