There has been a lot of talk lately about inflation, in great part because inflation has been so low for so long, but recently had a small spike. Unfortunately, when inflation is low, investors tend to forget it is a “sleeper risk,” gradually eroding their purchasing power and lowering after-inflation returns. Below are thoughts to consider.

Why does monetary policy matter when it comes to inflation?

Historically, periods of major government monetary policy stimulus, such as lowering interest rates, led to increases in inflation. The last decade has seen the longest and lowest period of interest rates ever, near-0% for a decade, plus other major stimulus programs designed to respond to the global financial crisis and the pandemic. During COVID, for example, Congress enacted a series of relief bills over the past year and a half, three of which provided for direct payments to American households. The CARES Act, the Consolidated Appropriations Act, and the American Rescue Plan have served as support for the unemployed, small businesses, state and local governments, schools and more. This government injection of cash into our battered pandemic economy and into the wallets of workers has been historic and creative, and almost certainly prevented the economy from a much worse fate.

Where has inflation been?

Over the last 10 years, inflation hovered steadily around an annual rate of about 2%, compared to the long-term average of about 3%, and the mid-teens during the late ’70s and early ’80s. More recently, the inflation rate (Consumer Price Index for Urban Consumers, or CPI-U) picked up speed. For the year ending May 2021, the all-items index increased 5.0%; the largest 12-month increase since the 5.4% increase for the period ending August 2008.

While inflation did rise, the historical relationship between stimulus and inflation may not be an accurate predictor of inflation as the economy recovers from the pandemic. Despite the massive stimulus programs, some economists, including many at the Treasury Department and the Federal Reserve, believe that current inflation increase will be “transitory.” They argue that it is a temporary effect related to pandemic reopening in what people hope is the tail end of COVID, combined with the individual stimulus checks program, pent-up demand, backlogged supply, and other factors. In theory, a recent uptick in wage growth might support continued increases in inflation, but to the extent that wage growth is due to a temporary labor shortage, wage growth may also be temporary. Also, some of those who maintained their jobs and received stimulus money may be more inclined to save the money and build up a rainy-day fund rather than spend it and boost prices.

That said, when bigger inflation increases have happened in the past, it was often for unexpected reasons and happened rather quickly. This time around the inflation, whether transitory or not, that does occur may take a different shape than in the past. Like what some called the K-shaped economic recovery, with different segments of the population experiencing different economic impacts, K-shaped inflation might occur, disproportionately affecting low-wage earners. Many of the items measured in the CPI-U, especially food, gas and housing have increased in recent months (albeit partly from depressed COVID levels), and these costs make up a large percentage of low-wage earner’s monthly living expenses, vs. those of higher-income earners.

At the same time, the Fed also recently signaled that they are prepared to raise rates sooner than the growth-oriented inflation-loose policy it previously projected, if economic growth and inflation continue in their current faster-than-expected direction.

How could all of this affect the stock market?

Higher wages and pent-up demand, among other factors, push prices up. Rising inflation eventually leads to the Fed raising rates. Higher rates increase the cost of borrowing, which reduces the disposable income of consumers and the profitability of companies, and puts downward pressure on stock prices. However, if wages don’t rise enough across middle and lower-income households, disposable income diminishes and spending is weak. This can cause company profitability and reasonable price rises to be weaker, which can also put downward pressure on stock prices, especially given that about 70% of GDP comes from consumer spending. Finding the right balance of employment, rates, and economic equality is not easy, but can create a more stable economy and less extreme stock price swings.

Can rising rates help?

For those that are approaching or in retirement, rising rates can actually be helpful. Those that are gradually reducing their stock market exposure and increasing bonds will experience higher average bond returns over the long run. There may be some bond volatility along the way, and it is the after-inflation return that matters most, but the effect can be beneficial as higher-yielding bonds are added to the portfolio.

What should you do now?

If your portfolio is already well-designed and globally diversified into an allocation of stocks and bonds appropriate for your risk profile, time horizon and financial goals, then no portfolio adjustments may be necessary. However, if you have an all-passive portfolio, including all-indexed bonds, you may have hidden risks. Indexed bond portfolios have higher “duration” or interest rate risk than most actively managed bond portfolios and often have less overall bond diversification, and often don’t have dedicated short-term bond components or other key bond asset classes for diversification. That higher interest rate risk increases your bond downside risk during a rising interest rate environment.

If you are uncertain about your asset allocation or if your time horizon or risk profile has changed, now would be a good time to review your investment plan. Also, if you haven’t refinanced your home or business debt, now may be a good time to get a low fixed rate before interest rates go up.

Additionally, whether you are an individual, a foundation/endowment, or a corporation, without an effective strategy for your short-term funds, there are designs to consider that might minimize or offset the impact of inflation, the negative effects of which will become even more noticeable as inflation rises. If you’re concerned about your current structure or want input on better steps you can take, contact us to speak with a personal wealth, foundation/endowment or retirement plan advisor.