The coronavirus outbreak, which was first detected in China, has infected millions of people in hundreds of countries and has left global governments, businesses, families and individuals around the world counting the costs.
In the U.S., as in many other countries, the response has been unprecedented, as federal, state and local governments, along with our central bank, have stepped in aggressively. And with states beginning to reopen for business while Congress debates additional stimulus measures, it’s important for investors to understand the inflationary implications that these massive economic stimulus packages might have on our economy, the stock and bond markets and our retirement plans.
The Federal Reserve
Since early March, the Federal Reserve has taken bold and drastic actions not seen since the Great Financial Crisis of 2008. Consider just some of the action by the Fed:
- An emergency 50 basis-point rate cut on March 3rd and another 100 basis-point rate cut on March 15th – a Sunday evening
- Quantitative easing originally capped at $700 billion of asset-purchases, but now unlimited
- Over $2 trillion lending program
In all, the Federal Reserve’s actions have provided the bulk of the more than $6 trillion worth of liquidity to our financial system. And economists are warning that we might be headed toward higher inflationary periods, maybe even hyperinflation, or worse: stagflation.
Inflation Definition and History
In simple terms, inflation is defined as an increase in the general level of prices for goods and services. Deflation, on the other hand, is defined as a decrease in the general level of prices for goods and services. If inflation is high, at say 10% – as it was in the 1970s – then a loaf of bread that costs $1 this year will cost $1.10 the next year.
Inflation in the United States has averaged around 3.3% from 1914 until 2019 and it has averaged about 3.7% for the past 60 years. For perspective, inflation reached an all-time high of 23.70% in June 1920 and a record low of -15.80% in June 1921. Most will remember the high inflation rates of the 70s and early 80s when inflation hovered around 6% and occasionally reached double-digits.
So how does inflation affect you? The answer is straight-forward: inflation decreases the purchasing power of your money in the future. Consider this: at 3% inflation, $100 today will be worth $67.30 in 20 years – a loss of 1/3 its value. Said another way, that same $100 will only buy you $67.30 worth of goods and services in 20 years. And in 35 years? Well your $100 will be reduced to just $34.44.
Hyperinflation, by extension, is exactly what it sounds like – inflation that is increasing at super-sonic speed. In technical terms, hyperinflation is described as inflation exceeding 50% per month. Although the U.S. has never experienced hyperinflation, other countries have. In fact, in October of 2019, the International Monetary Fund estimated Venezuela’s annual inflation rate for 2019 would be an astounding 200,000%. That’s hyper.
Every month, the Bureau of Labor Statistics, part of the Department of Labor, calculates indices that measure inflation:
- Consumer Price Index (CPI) – A measure of
price changes in consumer goods and services such as gasoline, food, clothing
and automobiles. The CPI measures
price change from the perspective of
- Producer Price Indexes (PPI) – A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.
Why is the Consumer Price Index so important? Well, for those receiving Social Security payments, a version of the CPI is used to calculate cost of living increases, for example.
Each month, the Bureau of Labor Statistics (BLS) collects “prices of food, clothing, shelter, fuels, transportation, doctors’ and dentists’ services, drugs, and other goods and services that people buy for day-to-day living. Prices are collected each month in 75 urban areas across the country from about 6,000 housing units and approximately 22,000 retail establishments (department stores, supermarkets, hospitals, filling stations, and other types of stores and service establishments).”
All this data is then weighted, adjusted and tied with a pretty bow before it’s released to the public.
The Components of the CPI
But we should never take a set of data at face value. For example, housing makes up 41% of the total calculation, according to the BLS in its latest press release and housing prices are up significantly in the past 8+ years.
In fact, according to the National Association of Realtors, the median existing-home pricefor all housing types in March was $280,600, up 8.0% from March 2019 ($259,700). Further, March’s national price increase marks 97 straight months of year-over-year gains.
Meanwhile, we are currently experiencing big deflation in the price of gasoline, because a gallon of gas has decreased by 24 cents from a month ago and $1.11 from a year ago, according to AAA. But gasoline only makes up about 3% of the total CPI calculation. And since most of us probably fill our gas tanks more often than we buy a house, we feel the impact of deflation in gasoline more (and when gas prices are rising, we feel the impact of inflation more).
How the Fed Tries to Control Inflation
With the Federal Reserve Act, Congress set three
very specific goals for the Fed: to promote maximum sustainable employment, stable prices, and moderate long-term interest rates.
In order to help the Fed stabilize prices, Congress gave the Fed a very powerful tool: the ability to set monetary policy. And one way the Fed sets monetary policy is by manipulating short-term interest rates in an effort to control inflation.
If the Fed believes that market conditions will lead to inflation, it will attempt to slow the economy by raising short-term interest rates – reasoning that increases in the cost of borrowing money are likely to slow down both personal and business spending. The flip side is also true too: if the Fed believes that the economy has slowed too much, it will lower short-term interest rates in an effort to lower the cost of borrowing and stimulate personal and business spending.
As you might imagine, the Fed walks a very fine line.
If it does not slow the economy soon enough by raising rates, it runs the risk of inflation getting out of control. And if the Fed does not help the economy soon enough by lowering rates, it runs the risk of the economy going into recession.
Currently, the Fed believes that “inflation at the rate
of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Fed’s mandate for price stability and maximum employment.”
Inflations and Wage Growth
Although inflation has inched upwards over the past five years, from a low of 0.7% in 2015 to 2.3% last year, the most recent CPI numbers show that inflation still has not found its way into the broad economy, despite all the money that government stimulus created. And if you look toward the Financial Crisis of 2008 for guidance, you’ll see that inflation peaked at 3.2% in 2011.
Part of the reason that inflation did not increase dramatically since 2008 and why it might not next year, is because sustained inflation doesn’t generally come only as a result of rising prices on goods and services. It is also due to wage increases which contribute towards inflation for two reasons:
- Higher costs for businesses (salaries are generally the largest line-item of a company’s expenses) and
- Higher consumer spending (consumer spending accounts for 2/3 of our GDP).
So, while some prices are up lately, don’t look for robust inflation to appear unless wage levels rise appreciably. And that is not likely to happen soon.
The Risk of Stagflation is Very Real
The term stagflation was first used by UK politician Iain Macleod in the 1960s when he was discussing current inflation that was accompanied by stagnation, calling it a "stagnation situation." It was used again during the 1970s oil crisis, when the U.S. saw five quarters of negative GDP growth along with double-digit inflation and unemployment approaching 10%.
Stagflation is defined as slow economic growth overall, high unemployment and rising inflation. Some might combine the economic growth and unemployment data into GDP and instead define stagflation as a period that sees declining GDP along with rising prices (inflation).
The truth is that there are consequences born from the coronavirus and resulting actions taken by the federal government and the Federal Reserve that are difficult to predict. If we fast forward to when economies begin to reopen, it stands to reason that production will be negatively impacted for quite some time as the recently unemployed slowly rejoin the workforce.
Further, whether there is a surge in demand from consumers and businesses, encouraged by historically low interest rates, remains to be seen. But the risk that we see slow economic output as prices (inflation) increase – the very definition of stagflation – is very real.
What Investors Really Need to Remember
Financial professionals preach that it is imperative that your long-term retirement strategies account for inflation and that you prepare for a decrease in the purchasing power of your dollar over time. And many financial professionals will suggest you assume inflation to be about 3% – its historical average.
If you’re wrong and we find that the inflation rate for the next 25 years turns out to be 2%, then the purchasing power of your retirement savings will be more, not less.
And it’s generally best to be on the side of caution.
Sources: bls.gov; dol.gov; fred.stlouisfed.org; census.gov; gasprices.aaa.com; fidelity.com; bloomberg.com
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial professional prior to investing.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
This article was prepared by Financial Media Exchange.
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