Inflation is in the news again after a long hiatus. The Bureau of Labor Statistics (BLS) reported in May that the broad inflation rate rose 4.2% over the past 12 months, the largest increase since 2008. Exactly what is inflation, and how does it impact investments?

Simply put, inflation (and its negative twin deflation) is a measure of the rate of change of the prices of goods and services in an economy. A little inflation in a capitalistic system such as ours is a good thing, since increasing prices provide an incentive to spend sooner before prices go up. In fact, the Federal Reserve’s (Fed) monetary policy currently targets 2% annual inflation as the goal for optimal economic growth. Contrast that with a deflationary period when prices are dropping, leading consumers to wait before making purchases, especially large ones, on the expectation that they’ll be able to get a better price in the future. Reduced consumer spending leads to reduced business spending, which can turn into a vicious cycle of economic decline when deflation persists.

There are myriad causes of inflation, but simplistically they can be categorized as supply-driven or demand-driven. Supply-side shortages of energy products, industrial metals, or other basic raw materials pushes their prices up, consequently forcing up the prices of other manufactured products as well as for construction and related services. Labor shortages resulting in production declines have the same effect. Increases in consumer demand for products and services will also force prices higher until supply catches up. (Recall how much toilet paper cost when the COVID pandemic started?) Liz Ann Sonders at Charles Schwab & Co. suggests that supply-driven inflation has a more deleterious impact on the stock market than demand-driven inflation does.

Government policies also impact inflation. Increased government spending as well as tax reductions can fuel inflation by putting more money into the pockets of businesses and/or consumers which ultimately increases demand. Tax increases and fiscal austerity measures generally have the opposite effect. Restrictive trade policies that limit the movement of capital & goods across borders tend to reduce supply and increase inflation while increased globalization does the reverse. The Fed uses monetary policy to try to balance inflation vs. unemployment. Sometimes they completely lose control as in the late 1970s when both reached double digit levels, coining the new term “stagflation.”

How does inflation affect the capital markets? In the short-term inflation is detrimental to both fixed income as well as to equity investments. In order to tamp down inflation, the Fed typically raises short-term interest rates through its control of bank borrowing rates. This has an immediate negative impact on bond prices. Over time, though, fixed income mutual funds replace older bonds with newer ones, whose higher rates enable the funds’ valuations to increase faster. In other words, when the inflation rate increases, bond funds will tend to initially experience a price hit followed by stronger returns than they had been experiencing previously. The interest portion of bond returns far exceeds the contribution from capital gains (as reflected in changes in bond prices). So in the longer-term higher interest rates is a positive for bond funds.

The situation is not dissimilar with stocks. When inflation starts to ramps up, those companies that have market pricing power (i.e. are competitively able to raise prices without significantly impacting sales volume) will do fine. For the rest there’s a short-term hit to profits as costs rise, but after a period of adjustment company profitability should bounce back. A diversified equity fund should consequently perform similarly to a fixed income fund: a short-term decline followed by higher longer-term growth, unless inflation remains high for a protracted period.

What’s happening today? It’s inevitable that a number of industry sectors (e.g. hospitality) will experience higher inflation as consumer demand ramps up from last year’s artificially low numbers. For others, supply problems are the cause. For example, used car prices were up 10% last month, likely fueled by the current shortage of computer chips impacting new car production. Whether the sharp spike in the overall inflation rate this month is merely transitory or the start of a trend remains to be seen.