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“With regard to interest rates, we continue to expect that it will be appropriate to maintain the current 0 to ¼ percent target range for the federal funds rate…”

— July 28, 2021, Statement by Jerome Powell, Chair of the Federal Reserve of the United States

Inflation worries surface

Inflation has not been a persistent and serious threat to the economy since the 1970s and early 1980s.  And that’s largely because the Fed knows how to defeat inflation: raise interest rates to onerous levels and quash demand in the economy via a serious recession.  In turn, companies lose the ability to rapidly boost prices, and employees no longer have the leverage to demand outsized wage hikes.

We don’t want to repeat that cycle.  At a minimum, however, we are starting to see upward and significant pressure on prices.  The Consumer Price Index for All Urban Consumers increased 5.4 percent, not seasonally adjusted, from June 2020 to June 2021 — the largest 12-month advance since the year-ended August 2008.  Consumer prices increased 4.7 percent from February 2020 to June 2021.  February 2020 was the last month before the COVID-19 pandemic began.

Fed officials continue to insist any increase in inflation will be “transitory.”  This is their word of choice in describing what they see as a temporary rise in prices tied to the reopening of the economy.  However, there are reputable economists on both sides of the inflation debate.  No one wants to see a return to the double-digit inflation of the 1970s, and the Fed is more likely to react now than was the case a generation ago.  Still, we don’t expect the Fed to lift interest rates anytime soon, as central bankers continue to insist their focus is on full employment, and any rise in pricing pressures is temporary.

The Fed insists it won’t raise interest rates until three things are true: the economy has reached maximum employment, inflation has reached 2%, and inflation is expected to remain above 2% for some time.  It’s a high hurdle for raising rates.  It suggests inflation alone isn’t enough to raise rates if the economy isn’t back to full employment.  It suggests the Fed is confident inflation won’t become a problem.

Markets and Inflation

Investing in bonds may seem counterintuitive: inflation is deadly to any fixed-income instrument, because it often causes interest rates to rise.  After closing at 1.74% on March 31, the yield on the 10-year Treasury eased to 1.21% at the end of July.  Expectations that the Fed won’t start tapping the brakes and raise interest rates, plus the belief that the spike in inflation is transitory, are leading to relative tranquility in the Treasury bond market, which means interest rates remain at relatively historical lows.  It also suggests the inflationary surge is transitory.

Interestingly enough, too much inflation is generally considered bad for an economy, while too little inflation is also considered harmful.  Stocks have a reasonable chance of keeping pace with inflation —but in this regard, not all equities are created equal.  For example, high-dividend-paying stocks may be driven lower—like fixed-rate bonds—in inflationary times.

Investors can enjoy a boost if they hold assets in markets affected by inflation.  Some companies reap the rewards of inflation if they can charge more for their products as a result of a surge in demand for their goods.  In other words, inflation can provide businesses with pricing power and increase their profit margins.  If profit margins are rising, it means the prices that companies charge for their products are increasing at a faster rate than increases in production costs.

However, companies can also be hurt by inflation if it’s the result of a surge in production costs.  Companies are at risk if they’re unable to pass on the higher costs to consumers through higher prices.  If foreign competitors, for example, are less affected by the production cost increases, their prices wouldn’t need to rise as much or as fast.  As a result, U.S. companies might have to eat the higher production costs, otherwise, risk losing customers to foreign-based companies.

The primary benefit of investing during inflation, of course, is to preserve your portfolio’s buying power.  You want to keep your nest egg growing.  While economists fret about rising inflation, investors have shrugged off recent CPI readings, driving the S&P 500 Index to a new high.  Maintaining a well-diversified portfolio is a prudent strategy.  Spreading the risk across a variety of holdings is a time-honored method of portfolio construction that is as applicable to inflation-fighting strategies as it is to asset-growth strategies