Wall Street likes to say they move from one Wall-of-Worry to the next Wall-of-Worry. The current Wall is inflation. Why should inflation be worrisome? In the short run, inflation is good for stocks, as earnings increase and debt becomes easier to repay. In the long run, however, the Fed will be forced to raise interest rates enough to reduce inflation. This often triggers a recession, which is not good for stocks You’ll recall the severe inflation of the 1970’s was cured by Fed Chairman Paul Volcker, who intentionally put our economy into recession. The stock market reacted badly in the short run but soon recovered and went on to set new record highs.
Recently, longer term interest rates have been rising. This may indicate inflationary expectations are increasing. When sellers expect inflation, they start raising their sales prices, which becomes a self-fulfilling prophecy, and causes inflation.
This suspicion of higher interest rates in the near future is fueled by both Monetarism and Keynesian economics. Under Monetarism, inflation results when money supply increases faster than productivity increases. With the Fed buying $120 billion of bonds every month (think QE), they are facilitating a rapid increase in money supply. Their view is that the average price of 10 widgets when the money supply is $100 is only $10 each, but will double to $20 each, if the money supply increases to $200. In other words, all the widgets for sale will “soak-up” all the dollars available.
Keynesian economics also suggests inflation in the near future. They believe when effective demand for widgets increase, while the supply of widgets stays the same, then buyers will compete against one another and “bid-up” the price of those widgets. The inflation of the 1970’s is usually attributed to continual deficit spending to pay for “guns-and-butter” — the Vietnam War plus The Great Society. The current trillion-dollar deficits might have the same impact.
My thought is that inflation is not in the near future. Despite persistent warnings of inflation since the Great Recession in 2008/9, we have seen little. While a lot of inflation is bad, a little is good. The Fed has had a 2% annual inflation goal for the last ten years. The current rate is only 1.4%. In addition, the Fed has already stated they will not react when inflation exceeds 2% by a small amount for a short time.
It is hard to over-emphasize how much fear the Fed has about deflation, which is a much more difficult problem than inflation. We have tittered on the precipice for years, and the Fed is unlikely to raise interest rates anytime in the foreseeable future, possibly tipping us into deflation. The slightly higher long term interest rates are not worrisome. Neither is inflation!
Another adage from Wall Street is . . . Don’t fight the Fed. That’s good advice!