Is Inflation Here to Stay? What Actions Should Investors Take?

You see inflation in your daily life; buying a car, staying in a hotel, filling up your tank and buying groceries. You hardly need economic charts to understand that. Inflation is caused by supply shocks and monetary expansion. An example of a supply shock is the oil crisis of the 1970s when OPEC reduced output quickly, raising prices to over $125 a barrel. Today’s labor shortages also represent a supply shock as salaries must rise for employers to fill open jobs. Inflation is also caused by an expansion of the money supply. The U.S. Federal Reserve expanded the money supply significantly over the past year to help mitigate the pandemic, expanding its balance sheet (making money available) by $4 Trillion. Its easy to dismiss both the labor market and money supply issues mentioned above as temporary results of the pandemic. However, the pre-pandemic economy was also primed for inflation. The U.S. Output Gap, which is the difference between potential production and actual production turned positive prior to the pandemic (Chart 1).

When the economy is producing above capacity, salaries and prices rise because demand outstrips supply. The labor market was also tight prior to the pandemic (Chart 2). The number of job openings exceeded the number of individuals looking for jobs in 2018 and 2019. News outlets reported on this as a positive development as “minimum wages” at various employers like Amazon and Walmart rose above $15/hour.

Whether you subscribe to Keynesian Economics, Modern Monetary Theory or “Economics by Shopping,” all signs point to rising inflation. The question is really “To what extent” will inflation rise and “What should I do” as an investor?

The good news is that you can leave your disco pants in the closet. We are not likely in for a repeat of 1970’s stagflation. The oil supply shock that kicked-off stagflation in the 1970s was the equivalent of oil prices north of $500 per barrel today. For reference, oil closed July at $74. Today, wages are rising, but I don’t know anyone making 5x their pre-pandemic salary. Supply chains bottle necks are also real, but as the suppliers come back on-line from the pandemic shutdown, each industry works through their issues.  From 1986 through the Great Financial Crisis in 2007, inflation averaged close to 3% on an annual basis. Since 2008, inflation has averaged merely 1.73%. Inflation could double, a significant increase, and run at 3.46% over the next decade to repeat levels from the 1980s and 1990s.

Its also good news that as investors we do not need to predict exactly whether rates will rise to 4%, 6% or 12%. We just need to know the direction. When inflation rises, interest rates rise to compensate lenders like banks and investors. When interest rates rise, bond prices drop. If your portfolio is allocated 30%, 40%, or 50% (or more) to bonds, inflation may cause those investments to lose value and not be as “stable” as desired. There are many ways to diversify a portfolio without undue interest rate risk; exposure to real-estate and infrastructure assets to name a few. Schedule a call with us to find investments that mitigate risk, generate income and provide diversification that make sense for your situation.