Don’t get me wrong. We aren’t returning to the white-hot inflation rate of 1980, which reached 14.8 per cent.
But there’s enough evidence to believe that a further upturn in inflation is coming. The question is how much inflation and for how long.
The Federal Reserve takes a sanguine view, saying it expects inflation to average 2.4 per cent this year and decline to 2.1 per cent by 2023. Inflation at that level would be no big deal. Long-term investors with well-diversified portfolios of stocks and bonds could pretty much ignore it.
But some highly qualified independent economists say the inflation rate could exceed 4 per cent and even reach 7 per cent over the next few years. My unscientific view is that the risk of that happening is less than 50-50 but still high enough to readjust some investment assumptions.
For one thing, if inflation does climb, the Fed would need to tighten financial conditions by reducing its bond purchases and by raising short-term interest rates. The markets would almost certainly become more volatile. Bonds would decline in value, because bond yields and prices move in opposite directions. The stock market would initially be unsettled.
It needn’t all be bad news, though, once the shock ebbs.
In inflationary environments, stocks often prosper, particularly those that pay high dividends. Home prices and commodities like gold, silver, copper and oil often rise, too. Treasury Inflation Protected Securities (TIPS), and Treasury inflation-indexed I-bonds, both introduced in the late 1990s, could hedge against rising prices. And bond portfolios would eventually generate better returns as investors shifted to higher-yielding securities.
That all comes from the standard playbook for investing in an inflationary period, and you may want to become familiar with it (or refresh your memory).
Kathy A. Jones, chief fixed income strategist for the Schwab Center for Financial Research, doesn’t anticipate sustained high inflation. But she expects a small increase, along with rising interest rates — the yield on the 10-year Treasury note is likely to reach 2.25 per cent this year, up from roughly 1.6 per cent now, she said.
“You probably wouldn’t want to hold long-term bonds” if inflation spiked further, she said, because they decline in value most sharply as interest rates rise. Shorter-duration bonds — and bond mutual funds and exchange traded funds — would incur losses briefly, but long-term, buy-and-hold investors needn’t worry much about it.
That’s because the total return for bonds, and for bond funds, comes from both price and yield. Yields in the bond market would be moving higher, even as their prices fell, and savvy investors could trade low-yielding bonds for securities with richer income streams, which would eventually produce greater returns.
That shift would occur beneath the hood of bond portfolios, in diversified index funds and well-managed active funds. Most important, she said, high-quality bonds — held individually or in funds — would probably buffer a stock portfolio in a sharp downturn, as they did when stocks crashed in February and March 2020. In short, many bond portfolios would generate small losses initially as inflation and interest rates rose, but would recover and still be worth holding.
As for stocks, the market is likely to be rocky if the Fed needs to respond to inflation — witness the 2013 “taper tantrum,” in which the Fed discussed reducing bond holdings and stocks briefly fell. But Jeremy J. Siegel, the University of Pennsylvania economist and author of “Stocks for the Long Run,” said that after the early turmoil, stocks should prosper — mainly dividend-paying (so-called value stocks), rather than tech growth stocks — as they have in past inflationary surges.
Siegel believes a bout of heightened inflation is already “baked in.”
“I’m expecting 20 per cent inflation, cumulatively, over the next three years,” he said.
The United States money supply, known as M2, has grown 30 per cent since the Federal Reserve and the government intervened in the economy in March 2020, he said. With such an increase, he said, “That’s pretty much it, you’re going to have a burst of inflation.”
There could be a year with 7 per cent inflation, one with 5 per cent, he said. “Who knows? I can’t time it.” He said that while the Fed will need to respond, it’s not likely to be facing a runaway wage-price spiral, requiring the harsh medicine of a recession, the cure imposed by Paul Volcker after he became Fed chairman in 1979. “This will subside,” he said, but the Fed will need to raise interest rates.
In recent years, prices have been so stable that the Federal Reserve has routinely failed to meet its goal of achieving an average inflation rate of 2 per cent a year.
But in an effort to ensure a sustained recovery that provides employment for people who might otherwise be left out, Fed officials say they are now comfortable with “overshooting” the 2 per cent inflation goal.
A modest uptick in inflation — below 3 per cent — would scarcely be noticeable. But sharp increases over a sustained period, like those of the 1970s and early 1980s, would be another matter.
Back then, prices of real assets like houses, gold and oil soared. Average mortgage rates exceeded 17 per cent, and interest rates on bank certificates of deposit approached 12 per cent. It was hard to know whether a 5 per cent pay raise was cause for celebration or despair.
The current inflation surge has been much milder so far, and because of the pandemic, it may be fundamentally different. A combination of supply shortages, extra savings and pent-up demand account for much of the price increases showing up in the official government figures — and at gasoline pumps, home supply stores, supermarkets and used car lots.
But the extent of those increases has been worse than many economists expected. The Consumer Price Index in April rose 4.2 per cent over the previous year, the biggest increase since 2008. The Fed’s preferred index — the Bureau of Economic Analysis’ personal consumption expenditure inflation measure — rose 3.6 per cent in April from the prior year, the biggest gain in 13 years. Stripping away food and energy prices, that core price index rose 3.1 per cent, the steepest increase since 1992.
The Fed and the government have injected so much money into the economy that the risk of a further, sustained inflation increase can’t be entirely discounted. Siegel is hardly the only economist to say so. Former Treasury Secretary Larry Summers has done so repeatedly. And Ray Fair, an econometrician at Yale, has projected that there is roughly a 30 per cent chance that inflation will be above 4 per cent next year and the year after if the Fed does not tighten monetary policy. But, he said, there is considerable uncertainty to any prediction in the current environment.
I certainly can’t predict the inflation rate. Yet I do remember the 1970s, when it was sensible to think that a dollar would be worth only 80 cents in three years — unless it was invested in stocks or real estate or gold. That is emphatically not where we are now, but for the first time in years, it seems sensible to get (back) into the habit of thinking about inflation.