Interest Rates, Inflation, and Investment Strategy
Part 2: Understanding Inflation
Has rising inflation got you down? In our last piece, “Understanding Interest Rates” we explored how rising and falling interest rates can impact a healthy economy. Today, let’s add inflation to the conversation.
How Do We Measure Inflation?
Inflation is the rate at which money loses its purchasing power over time. As you might guess, there are many ways to measure such a squishy figure. There are various economic sectors, such as energy, food, housing, and healthcare, which can complicate the equation by exhibiting wildly different inflation rates at different times. There is ongoing debate over which figures are most relevant under what conditions.
There also is today’s inflation rate, versus the rate at which inflation has changed or is expected to change over time. For example:
- Measured by the U.S. Consumer Price Index, inflation stood at a February 2022 annual rate of 7.9%, fueled significantly by increased energy prices.
- Measured by the Intercontinental Exchange (ICE) U.S. Dollar Inflation Expectations, 1 Year Expected Inflation was at 5.74% on March 23, 2022.
- Measured by the Federal Reserve’s 10 Year Break-Even Inflation Rate (the U.S. market’s expected average annual inflation rate for the next 10 years), expected inflation was hovering at around 2.94% on March 23, 2022.
While that’s a wide range of numbers for seemingly the same figure, they all share one point in common: By nearly any measure, inflation is higher than it’s been in quite a while. One need only visit the $1.25 Dollar Tree (or nearly anywhere else these days), to realize that $1 doesn’t buy what it used to.
But what should we make of that information? As usual, it helps to consider current events in historical context to discover informative insights.
Inflationary Times: Past and Present
Unless you’re at least in your 60s, you’ve probably never experienced steep inflation in your lifetime—at least not in the U.S., where the last time inflation was as high (and higher) was in the early 1980s. After years of high inflation that began in the late 1960s and peaked at a feverish 14.8% in 1980, Americans were literally marching in the streets over the price of groceries, waving protest signs such as, “50¢ worth of chuck shouldn’t cost us a buck.”
During his 1979–1987 tenure, Federal Reserve chair Paul Volcker is credited with routing the runaway inflation by ratcheting up the Federal target funds rate to a peak of 20% by 1980. (Compare that to the recent increase to 0.05% as discussed in our last piece.) Aimed at reducing the feverish spending and lending that had become the status quo, Volcker’s strategies apparently effected a cure, or at least contributed to one. By 1983, inflation had dropped considerably closer to its cooler target rate of 2%, around which it has mostly hovered ever since. Until now.
The Inflationary Past Is Not Always Prelude
Why not just ratchet up the Fed’s target rates as Volcker did? Unfortunately, it’s not that simple.
First, as described in this commentary, “Should We Be Scared of Inflation?” there are several broad categories—such as supply and demand, rising labor and production costs, and a nation’s monetary policies—each of which can contribute to inflation individually or in combination. This means each inflationary period is borne of unique circumstances. So, even if a “treatment” seems relatively reliable, you never know for sure how each “patient,” or economy, will respond.
Second, even if an inflation-busting action does work, it’s not unlike treating cancer through aggressive chemotherapy. Left unchecked, the side-effects can be worse than the disease.
Volcker’s actions are a case in point. The higher target rates not only tamed inflation, they weakened the economy significantly, leading to an early 1980s “double dip” recession and high unemployment. Overall unemployment hovered above 7% for several years, with some sectors such as the construction and automotive industries experiencing double-digit figures. Even if the outcome was worth the pain involved, it’s not a course one embraces with enthusiasm.
“If/Then” Stage Two Thinking
Are we doomed to reach double-digit levels of inflation this time, face another painful recession, or both? As always, time will tell. However, in the face of today’s challenges, we choose judicious optimism over paralyzing fear. This is not because we’re naïve or blind to the facts, but because we are guided by an economic principle known as stage two thinking.
Economist Thomas Sowell has described staged thinking in his pivotal book, “Applied Economics: Thinking Beyond Stage One.” Basically, before acting on any event’s initial impact, it’s best to engage in stage two thinking, by repeatedly asking a very simple question:
“And then what will happen?”
By applying stage two thinking to inflation, we can accept that, yes, inflation has become uncomfortably high. Labor costs, supply constraints, low-interest rates, and high spending have all likely contributed to inflated costs, which can then twirl around and further aggravate these same influencers. In the resulting tango, inflation could spin out of control.
But then what will happen? In reality, next-step responses are already taking place. The Fed has raised interest rates once, and hopes to continue raising them throughout 2022. Likewise, businesses are revisiting their growth plans, and consumers are thinking twice about their purchases, especially in markets where inflation is having its greatest impact.
It probably won’t happen overnight, but these next steps should chip away at inflation. True, this could lead to a recession … or not. We hope not. Either way, then what will happen? Once again, governments, businesses, and individuals will likely adjust their behaviors and expectations in response. And so on.
Investing in Inflationary Times
Even if odds are heavily stacked in favor of our taming inflation over time, this is not to suggest it will be easy. And even if we “win” in the end, it’s unlikely it will be obvious until we are able to look back at the events in hindsight. As such, as we press forward, you may repeatedly question what these influences mean today to you and your investments. We’ll describe our take on that in the final, part 3 installment of this series.