What if the Fed Reignites Inflation?
Much talked about, but little seen these past several years, inflation continues to be a source of heated discussion among economists, members of the Federal Reserve, and investors of all types. The latest data suggests inflation will remain subdued, at least for the time being. In November, the advanced estimate of gross domestic product (GDP) growth came in at 3.3%, consumer confidence was up and hiring was again robust, but headline inflation was flat at 1.8%.1
But, here’s a question worth considering: What happens if the Fed actually succeeds in reigniting inflation? And, what if that inflation doesn’t conveniently stay capped at the Fed’s 2% target?
Investors must constantly weigh what might be thought of as low probability but high-impact outcomes. The return of significantly above-trend inflation is one of these.
We have been living through a period of historically unprecedented actions on the part of global central banks, most of which have been focused on reigniting some kind of upward movement in prices. One of these actions, quantitative easing (QE), is now drawing to a close in the U.S., and other central banks appear likely to follow over the next year (12 to 18 months). The impact of this is generally thought to be deflationary, but no one really knows.
In fact, some economists speculated that the original QE program would be deflationary, in part by pumping up unsustainable demand and production. If we assume that has been the case (and there’s by no means agreement among economists that it was), would the end of QE programs actually turn out to be inflationary?
No one can say for certain, but the return of inflation to a level above the Federal Reserve’s 2% target could quickly introduce an investing environment substantially different from what has been the norm for the past 10 years. Bond prices would move down as rates rise, and stocks might reprice, based on new calculations of risk in the equity markets.
In one regard, investors might welcome this, as yields on bond funds would migrate upwards. Alternative funds – which incorporate a mix of assets, including some that research has shown may benefit from rising price levels – would also be worth a look. Commodities, too, are among the assets that tend to do well when inflation accelerates.
At this point, though, it’s hard to find too many takers for the “return of inflation” thesis. What we’ve seen instead is a flattening of the yield curve, as long-term rates have come down or stayed steady as short-term rates have moved up. Those looking for a straw in the wind might focus in on 3Q wage growth, which came in at a 2.7% growth rate in the period.
In the long history of Wall Street, events tend to move along in a relatively predictable way until one day they don’t. Consistently anticipating those inflection points has proven to be virtually impossible. When you look at the records of those who claim to see around the corner, you usually find one (or both) of two things: They’ve been predicting the same thing for years and been wrong for most of that time, or they’ve made a single correct prediction and never successfully repeated it. There are rarely, if ever, second acts among the prognosticators of major market turning points.
This goes back to the most basic principle of investing: Stay diversified. And in the current times, that may mean at least a nod in the direction of the possibility that inflation will one day return.
1. IndexIQ, as of 11/30/17.
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Commodity: Investments in instruments and companies that are susceptible to fluctuations in certain commodity markets. Any negative changes in commodity markets (that may be due to changes in supply and demand for commodities, market S-4 events, regulatory developments or other factors) could have an adverse impact on those companies.
A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for other debt in the market, such as mortgage rates or bank lending rates, and it is also used to predict changes in economic output and growth.
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