You may have noticed that the topic of inflation is getting more attention. Those who were around in the 1970s likely still remember when rapid rises in the cost-of-living were of great concern. But for those who are younger, the concept of an extended period of high inflation may seem strange to you as you have never experienced it.
The conventional wisdom is that during periods of rapid economic growth, inflation is likely to pick up. There is speculation that the economic recovery underway now, in conjunction with dramatic stimulus measures by the federal government and the Federal Reserve, may set the stage for another bout of significant inflation. This would be a dramatic change.
In the past nine years, the annual change in the cost-of-living never topped 2.3% (U.S. Bureau of Labor Statistics, Historical Consumer Price Index for All Urban Consumers (CPI-U); U.S. city average, all items). The last calendar year when inflation was measured at more than 3% was in 2011. It last rose as high as 4% in 1991. By contrast, from 1974 to 1981, the cost-of-living soared each year by an average of 9.4%. In that eight-year span, the fundamental cost of living in the U.S. doubled.
Inflation can take a toll
When inflation is in check, it becomes more likely that the standard-of-living for individuals and families will improve. Interest rates tend to track with inflation trends, so lower cost-of-living increases usually keep interest rates down. That makes borrowing cheaper for purchases like homes and automobiles. By contrast, when the pace of change in the cost-of-living picks up, it makes most things more costly for consumers, potentially slowing economic activity.
History indicates that high inflation can result in a more challenging investment environment. If interest rates track higher with inflation, the market value of bonds declines (bond prices and interest rates move in opposite directions). In the high-inflation period of the 1970s and early 1980s, stock markets struggled as well.
Understanding the inflation rate
The most cited measure of inflation, the Consumer Price Index, weighs changes in prices for a basket of consumer goods and services. It helps give individuals and policymakers an idea of cost-of-living trends over time. The most important number focuses on “core” inflation, a measure of goods and services that eliminates cost changes for food and energy-related commodities. It is felt that components like food and energy are subject to wild fluctuations that can be caused by geopolitical developments or weather events. Because of their volatility, they are considered a less reliable barometer of broader economic trends.
Why the concern today
There is growing optimism that as the rollout of COVID-19 vaccines continues, the economy will gain steam. At the same time, economy is still getting a lot of support. The federal government has provided six trillion dollars of stimulus in the past year. This has come in the form of direct payments to individuals, enhanced unemployment benefits, special support programs for businesses and aid to local and state governments.
Likewise, the Federal Reserve has kept interest rates at historic lows and purchased billions of dollars’ worth of bonds to help add liquidity to the markets.
Will the confluence of a steady return to normalcy along with dramatic fiscal and monetary stimulus light enough of a fire in the economy to make inflation a bigger concern? Only time will tell, but it is an issue that bears close watching. Be careful not to overreact to short-term upswings in inflation, but it is always good to have a long-term plan in mind to respond to a changing environment. Consult with your financial advisor to discuss how your portfolio is positioned for the future.