In early 2021, the U.S. government rolled out another massive round of economic stimulus
aimed at offsetting the damage done by the COVID-19 pandemic.
But there’s a potential side effect that some investors and economists fear could actually
hurt the economy even more: inflation.
Inflation is the rise in cost of goods and services.
Basically, it’s how much your money loses value over time.
Many economists believe inflation isn’t all bad; it typically goes hand-in-hand with
economic growth.
And too little inflation, known as disinflation, or falling inflation called deflation, can
be a sign of a struggling economy.
But too much inflation too quickly, called hyperinflation, can lead to economic instability
and market crashes.
While many policymakers and economists think hyperinflation as a result of economic stimulus
is unlikely, others aren’t so sure.
Understanding what causes inflation, how it’s measured, and how the government manages it
can help you take steps to prepare your portfolio.
So, what exactly causes inflation?
The most common theory is based on supply and demand.
Basically, the more money there is in the economy, the less it’s worth, and vice versa.
In order to stimulate economic recovery from the COVID-19 pandemic, the Federal Reserve
and the federal government did things like cut interest rates and send checks to encourage
Spending essentially creating money.
You can see it in the M2, a calculation the Fed uses to track the money supply.
It grew from about $15.5 trillion to more than $19.6 trillion from February 2020 to
February 2021.
This degree of growth is unprecedented in the United States.
Some worry that the more money the government floods into the economy, the less each dollar
will be worth, starting a spiral toward hyperinflation.
The closest the United States came to hyperinflation was during The Great Inflation from 1965 to
1982.
During this time, there were four recessions, two energy shortages, and wage and price controls.
The Consumer Price Index, or CPI, which measures inflation by tracking the prices of common
goods like food, housing, clothing, transportation, and more, hit a high at one point of nearly
15% year over year growth.
The higher inflation translated to higher interest rates.
Mortgage rates climbed to 18.63%.
And the unemployment rate climbed to 9.7%.
All these factors led to a stagnant stock market; the Dow Jones Industrial Average struggled
to move above the 1,000 level for nearly two decades.
So, should you be concerned about hyperinflation?
Many economists and policymakers think the risk is low.
In March 2021, Federal Reserve Chairman Jerome Powell testified before Congress that deflationary
pressure over the last 25 years should help offset the risk of inflation.
One deflationary pressure is productivity and efficiency gains from technology and globalization.
Advances in computing, telecommunications, and networking have elevated productivity
and kept labor costs low.
And global free trade has let companies seek lower cost materials and labor abroad and
use just-in-time production systems to avoid the cost of storing inventories.
As a result, employment has been relatively soft since the Great Recession and took a
major hit from the pandemic.
In January 2021, long-term unemployment was approaching 2010 levels, and wage growth for
many workers has been underwhelming.
Finally, slower economic growth has helped keep inflation low.
Since 2000 and prior to the COVID pandemic, annual U.S. Gross Domestic Product, or GDP,
a measure of income for a country, has stayed below 3% annually, keeping inflation low with
it.
Considering all these factors, many economists and policymakers see plenty of room for the
economy to grow before reaching dangerous levels of inflation.
However, despite low overall inflation, there have been pockets of rising prices.
For example, in late 2020 and early 2021, supply chain disruptions and high demand caused
lumber prices to rise more than 170% in just 10 months.
The rising costs of lumber is adding $24,000 to the price of a new home.
In February 2021, food inflation for the previous year was 3.5%.
Some of this was due to supply chain disruptions but also rising oil prices, which increase
the cost of transportation.
In March 2021, the CPI rose 0.6% for the month and was up 2.6% from the previous year.
Much of this was driven by a 9.1% spike in gasoline prices.
Remember that inflation is part of normal economic growth.
Traditionally, the Federal Reserve has an inflation target of 2%.
Chairman Powell said the Fed will allow inflation to run hotter than normal to spur economic
growth.
Powell and Treasury Secretary Janet Yellen have both said the risk of hyperinflation
was small and that the government has tools to address inflation if it does occur.
However, former Treasury Secretary, Larry Summers, is less optimistic and pointed to
the Fed’s past inability to slow an overheated economy without causing a recession.
Harvard economist Greg Mankiw warned that the economy may overheat if inflation exceeds
3% for the next five years.
If you’re concerned about how inflation could impact your investments, there are a
few things you can do.
First, remember that historically speaking, stocks have tended to outpace inflation over
the long run.
From 1926 to 2020, inflation has averaged 2.9% a year while stocks have returned an
average of 10.3%.
This is well above bonds and cash.
Of course, past performance is no guarantee of future performance.
Next, consider value investing, Value investing is a strategy that selects stocks that appear
to be underpriced, as opposed to growth investing, which selects stocks whose prices are based
on high expectations for future growth.
In the event of hyperinflation, borrowing costs may rise.
This may hurt growth companies, which tend to rely more heavily on debt, while value
companies are less likely to borrow to produce future earnings.
Also consider TIPS, or Treasury Inflation-Protected Securities.
An initial investment in TIPS increases with inflation as measured by the CPI.
In other words, if the CPI rises, the value of the principal invested in TIPS and future
interest payments will rise as well.
When TIPS mature, an investor is paid the adjusted principal or original principal,
whichever is greater.
Of course, TIPS are subject to certain risks.
They tend to have lower yields than other treasuries, their value will decline if interest
rates rise, and principal adjustments can be taxed before the bond is sold or redeemed.
Whether you’re concerned about hyperinflation or believe the Fed will be able to keep it
under control, it’s important to monitor inflation and take steps to help protect the
purchasing power of your money.