Inflation has been nonexistent for most of the past decade, but now it is making headline news. It is important to distinguish what it is, why it is important, and the impact that it has on consumers and financial markets.
Inflation in its simplest definition is an imbalance between supply and demand-specifically there is a reduction in supply and an increase in demand, which leads to increased prices on goods and services. The reason inflation is getting so much attention is because it has been dormant for decades. For reference, the Consumer Price Index (CPI) was 8.5% year over year in March, 2022. This figure moderated slightly in April, 2022 down to 8.3%, but both of these figures are near the highest levels in more than 40 years1. There is not one specific reason for higher inflation, but rather several factors that have led to a perfect storm. For example, the historic, and arguably imperative, monetary and fiscal policy implemented at the height of the global pandemic left the consumer flush with cash. This led to an increased demand for goods and services. While there was an increase in demand, there was also a reduction in supply due to several factors which are noted below. Hence, the perfect storm, affecting both the supply side and the demand side. Ultimately, the impacts are felt both at the consumer level and in financial markets.
On Main Street, as a consumer, you don’t need a monthly inflation report to let you know that prices for goods have increased. This has affected the price of gas, groceries, clothing, etc. There are several exogenous factors contributing to this rise in cost. On the supply side, China’s zero-COVID policy is reducing their workforce, hence their ability to export goods. Also, the war between Russia and Ukraine impacts the amount of commodities that that can be exported out of the two commodity rich nations. On the demand side, consumers emerged from the early days of the pandemic in a relatively secure financial position; resulting in pent up demand for consumer discretionary items, travel and more. To reiterate, it is this imbalance between supply and demand that has led to the levels of inflation that persist today.
From a financial markets perspective, inflation has benefited real asset prices (i.e. homes and other real estate), but has had a predominantly negative effect on both the stock and bond markets. There are several reasons for this. One could argue that a good portion of this negative performance is driven by higher interest rates (negatively impacting both stocks and outstanding bonds), as well as the uncertainty of how the Federal Reserve (Fed) is going to react to the increased inflation. The Fed is only able to impact one side of the equation and that is the demand side. They are in the early stages of raising the Federal Funds rate in an effort to reduce demand for large purchases such as homes, but they have absolutely no control over increasing the supply of goods, gas or groceries. Also, whereas the consumer feels and cares about inflation, the Federal Reserve is concerned about the rate of change of inflation. For instance, if the annual CPI goes from 8.3% to 7.5% or lower, the Fed will view this favorably and may not need to hike interest rates as aggressively as originally signaled.. This might send a positive message to both stock and bond markets. The Fed’s precarious job is trying to fight inflation while keeping the economy from going into recession. This is what they call an attempt at a “soft or softish landing”.
Given the fluid nature of our current inflationary environment, we think it is premature to predict where inflation goes from here. Rather, we will continue to closely monitor the trends in inflation and do our best to ensure that our clients’ portfolios are positioned to weather this storm. Additionally, we will look for clues from the Fed as they attempt to reach the desired soft landing.