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7 Things to Remember When Inflation Returns

Economics / Inflation Aug 30, 2016 - 05:18 PM GMT

By: John_Mauldin

Economics

The problem for much of the global economy since the Financial Crisis of 2008 has been a lack of inflation. The banking system seized up, and loans were hard to come by for a couple of years. This shock hurt economic growth and knocked inflation down to near zero. Many major economies were hit with outright deflation.

In response, global central banks—including the US Federal Reserve—began a massive series of stimulus programs. The goal was to help their national economies get back on track. But, the results have been mixed. The US economy is one of the few to show signs of life over the last year or so.


Although there has been a downward trend in GDP for the last few quarters, the US economy grew at a solid 3% clip barely a year ago. Many economists expect a return to 2% plus annual growth within six months.

Economies tend to move in cycles. So, we will undoubtedly see a return to inflation. In fact, there are signs that suggest inflation is starting to pick up in the US.

Food prices have been moving up. Oil and other commodity prices are also gradually inching up. This means producers are paying more for materials, while consumers are paying more for goods and services.

Wages in the US are starting to increase again, and more money in consumers’ pockets is vital for an expansionary economic cycle.

Inflation will not happen overnight. The process will play out over months as the economy revs back up. Make sure you’re ready with these seven important things to keep in mind when inflation returns.

Each inflation cycle is unique

An analysis of historical inflation cycles shows that every cycle is unique. This means you can’t count on real estate and mining stocks to move up during this inflationary cycle just because they did the last time. You have to understand what is similar and what is different about today's macroeconomic situation to make accurate predictions.

For example, will real estate keep going up rapidly when interest rates start moving up, especially since both home and commercial real estate prices have increased a lot in the last few years? These are the kinds of questions you need to ask when investing in an inflationary environment.

That said, you don’t want to get too fancy. After some due diligence, as long as you’re investing in a firm with solid management and a well-thought-out business model, there’s every reason to expect it will continue to perform well during times of inflation.

Income/Wealth inequality will get worse

All of us feel the effects of inflation. This is especially true for the poor. Inflation acts as a tax and has a regressive impact on lower-income individuals and families. This is because those with limited budgets and little to no savings spend a higher share of income on the basics—food, shelter, utilities, transportation, etc. It’s a different story for those with more money.

If you’re only spending 25% of your income on life’s essentials, a 10% rate of inflation is hardly noticeable. If “the basics” consume 95% of a family’s income, a 10% rise in costs means a cut in spending just to get by.

Interest rates will climb

Interest rates paid on bank deposits by the central bank are one of the key tools central bankers use to control inflation. The rates set by central banks (like the Fed) are the primary factor in the rates paid by banks on deposits or the rates they charge for loans.

The inflation-fighting logic is that raising interest rates will discourage people from taking out loans. This, in turn, slows down an economy.

By the same token, decreasing interest rates stimulates an economy by encouraging lending. The US Fed just began to move up interest rates a few months ago, but has not taken any further steps.

Given the current macroeconomic situation, it’s likely interest rates will go up. The key questions are… when will the Fed act? and how much will the FOMC boost rates?

Bond prices will fall

Bond prices are inflation sensitive. When interest rates go up, bond prices fall because the lower yield offered on the older bonds is now being eaten up by inflation.

When the economy starts to rev, and the Fed finally gets serious about normalizing interest rates, you can expect bond prices to drop and bond yields to climb. The key is timing.

Wages will rise

Inflation also boosts wages… over time. At some point, inflation takes too big of a bite out of workers lifestyles. When it does, employers have to raise wages to avoid unhappy employees (falling productivity, etc.).

That said, it does take some time for wages to chase inflation. Wage increases are typically doled out every six months or a year. That gives employers a chance to phase in higher wage costs to minimize the impact on their bottom line. But it also means that wages never quite keep up with costs.

Capital investment may decline

History shows that when inflation becomes a big concern, capital spending goes down. High inflation (or large swings in the inflation rate) lowers business confidence about future costs and a company’s ability to raise prices. And this uncertainty can lead to reduced capital investment spending.

3% US inflation could arrive sooner than you think

Determining current inflation rates is pretty basic. But, to project what inflation will look like in six months, a year, or two years from now is much trickier.

This is especially true in expansionary cycles, ie, times of increasing inflation. The current inflation rate in the US is around 1%. Economists at the World Bank (known for their conservative approach) project that the US inflation rate (CPI) will hit 2.5% in 2018 or 2019.

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