How Big A Concern Is Inflation?

Despite an economy that continues to surprise on the upside, the volatility for both the stock and bond markets remains linked to inflation expectations.  It seems that every economic statistic that is released is thoroughly dissected by analysts for its possible impact on inflation. As I write this newsletter, the employment numbers that were released for April were lower than Wall Street estimates. Optimism soared that wage inflation would finally subside providing the Federal Reserve with the ammunition to finally lower short term interest rates and add fuel to the stock market.  The final tally for that trading day was a gain in the Dow Jones Industrial Average of almost 500 points on what would generally represent lackluster economic news.

Inflation had not been a concern for more than 40 years since Paul Volcker, the Federal Reserve Chairman in the late 1970’s into the 1980’s, squeezed inflation out of the economy by raising short term interest rates to historical highs.  In fact, over the past 30 – 40 years, the bigger concern for many economists was deflation or declining prices which has a deleterious impact on the economy.

The most commonly used gauge of inflation is the CPI (Consumer Price Index).  It tracks the average price of goods and services over time and measures core inflation that excludes food and energy which tend to be volatile and impacted by non-economic factors such as weather and geo-politics.  Beginning with the onset of the pandemic where supply chains were disrupted, the CPI rose rapidly peaking at a 12 month inflation rate of 9.3% last June. It was fueled by massive stimulus spending by the federal government in an attempt to keep the economy afloat.  The word transitory was often used to describe the view of many economists that high inflation would be fleeting.  Despite a contradictory view by other economists, in retrospect, it does appear concerns about persistent high inflation were overly pessimistic.

While the majority of supply chain issues have been resolved, inflation has remained sticky in the 3.5-4% range above the Federal Reserve target of 2%.  The main culprits are the aforementioned wage inflation along with rising housing costs and exacerbated by meteoric increases in selective living expenses such as premiums for automobile insurance and homeowners insurance (including flood insurance) in specific regions of the United States.

Another controversial factor is the possible effect of the passage by Congress of the Inflation Reduction Act which focuses on the rebuilding of our infrastructure and promotion of green energy.  While both of these goals are important for the future growth of our economy, it can be argued that the debt required to fund these expenditures may accelerate inflation in the short run.  

It is my view that the current inflation rate is not an impediment to the continued growth of the economy.  In fact, a little inflation is welcome as asset values grow and consumers spend.  Obviously, many consumers have been painfully affected by the large increase in living expenses often without a commensurate increase in income, and it is understandable that their focus is on recent inflation that has hindered their ability to pay their bills.  Going forward, progress on two fronts would significantly reduce the inflation rate – additional workers to fill the void left by retiring baby boomers and a large increase in housing starts.  A regulated sensible immigration policy would expand the pool of new workers eager and able to join the labor force thus lessening the rise in wages while an increase in new housing would likely lower both rents and home prices.

In the meantime, should inflation remain an issue, there are various asset classes that would likely benefit such as investments in infrastructure, commodities (including gold), Treasure Inflation Protected Securities (TIPS) and real estate. Of course, other factors can affect these asset classes and allocations need to be carefully considered in the context of an entire portfolio before any final decisions should be made.

Sincerely,

Clifford L. Caplan, CFP®, AIF®

May 20,2024