Inflation continues to accelerate. How far and fast it rises will be critical to the economy and to stock and bond prices.
Federal Reserve officials say that the recent rise in inflation is primarily due to short-term factors, such as recovering energy prices and supply chain problems.
But inflation might not be temporary.
Prices of commodities and finished goods are rising sharply. Lumber and copper recently hit all-time highs. Corn and other agricultural commodities are surging.
Production of many commodities was slashed during the pandemic, and it takes time to ramp up production. It will be a while before supply meets demand.
Surveys of business owners reveal numerous supply problems across the economy. The owners report that they must pay higher prices and anticipate passing the price increases on to customers.
Also, business owners consistently report that their top problem is finding enough qualified workers to fill job openings, though the number of people employed is much lower than before the pandemic.
Businesses are paying higher wages and taking other measures. For example, some fast-food restaurants now are offering hiring bonuses to new employees.
During the last few decades, wage and price increases weren’t wide-spread enough to make their way into final prices and the Consumer Price Index (CPI). Inflation in the service sector was offset by deflation in the goods sector.
Other factors include globalization, disinflationary monetary policies and policies favoring business over labor restrained inflation.
Those disinflationary forces are fading. Many at the Fed believe the recent swelling in demand will subside. But the economy still is recovering from the downturn and has a long way to go. Demand is continuing to build for many goods and services and is outstripping supply.The first and most direct effect of the fiscal and monetary policies of the last year or so was on the investment markets, especially stocks. But all that money is sloshing around and affecting the economy.
Also, the fiscal stimulus is targeted to directly stimulate the economy. The additional stimulus and spending planned by Washington will enter the economy directly.
As I detailed in several episodes of the Spotlight Series last year, we’re duplicating fiscal and monetary policies last used during World War II and historically used only during wartime.
The policies eventually lead to inflation.I continue to recommend that a portion of portfolios be in inflation hedges, such as gold, commodities, real estate and Treasury Inflation-Protected Securities (TIPS). So far, these policies have been good for stocks. But how stocks respond from here will depend on interest rates.The Fed is holding short-term inter-est rates down while long-term rates have increased a bit.
That is known as a steepening of the yield curve and usually is good for stocks and other growth investments. It means the markets, not the Fed, are pulling rates higher, because of expectations for higher economic growth. It is bad for bonds and some other interest-sensitive investments.
But if the Fed reduces monetary expansion and allows short-term rates to rise, that will hurt many stocks.
Technology stocks and others that depend on high growth rates and profit margins would be especially vulnerable.
There already is a bubble in emerging technology companies that are losing money but have high stock market valuations based on optimism about their growth prospects.
Also, negative real (after inflation) interest rates help stocks. They push investors to take more risk in search of positive real returns. At some point, inflation will rise to the point that the Fed will reduce monetary expansion.
Until that happens, I recommend a diversified portfolio that includes inflation hedges and growth stocks, including some international stocks.