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As investors, we often worry about the effects of inflation eating into our returns. But might higher inflation rates actually be a good thing for the U.S. economy?
That’s an argument The New York Times made in an article published earlier this week titled, “In Fed and Out, Many Now Think Inflation Helps.” The writer, Binyamin Appelbaum, says that several Federal Reserve members – including vice chair Janet Yellen, nominated to become chair in January – believe that higher inflation rates would help jumpstart the sluggish U.S. economy.
Here’s what Appelbaum wrote:
“Economists … have long argued that a little inflation is particularly valuable when the economy is weak. Rising prices have helped companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow more money and spend it more quickly.”
Right now, inflation is close to historic lows. In September, the inflation rate dipped to 1.2%, the second-lowest monthly rate since 2010. The Fed actually wants the rate to be closer to 2%. It doesn’t want to risk the type of deflation that has crippled Japan’s economy in recent years. The yen has been in general decline since the late 1990s. As a result, Japan – which in the ‘80s and early ‘90s appeared destined to become the world’s premiere power – has become an afterthought in the global economy.
Current Fed chair Ben Bernanke is wary of suffering Japan’s same fate. In July, Bernanke said the following:
“Low inflation is not good for the economy because very low inflation increases the risks of deflation, which can cause an economy to stagnate. The evidence is that falling and very low inflation can be very bad for an economy.”
The reverse effect, of course, is inflation rates rising too high. High inflation punishes retirees living on a fixed income and discourages lending. The sticker shock of higher prices can also scare some consumers away.
For investors, the effects of inflation on returns can be profound. For example, if your portfolio has an annual return of 12% in a year when the inflation rate is 6%, then suddenly your real return is sliced in half.
Conversely, high inflation rates can boost market returns. The last time U.S. inflation topped 6%, in October 1990, it sparked a seven-year bull run for the S&P 500 – the longest stretch in the history of the index without a 10% pullback. After Hurricane Katrina caused the inflation rate to spike to 4.7% in late 2005, stocks also continued to climb before peaking in mid-2007.
Stocks don’t need any help now, with all three U.S. indices at or close to all-time highs. But markets are rising in spite of sluggish economic growth and an unemployment rate that, while much lower than it was during the depths of the recession, is still well above historical averages at 7.2%.
Evidence supports economists’ claims that high inflation can give the economy a much-needed jolt. Within a year of inflation hitting 4.7% in late 2005, the unemployment rate dipped to a 10-year low of 4.4%. GDP growth also more than doubled, from 2% in mid-2005 to 5% in mid-2006.
To be fair, there are examples of high inflation rates hurting the economy. The highest inflation rate this century was 5.6% in July 2008 – just before the worst recession since the Great Depression.
But history shows that high inflation isn’t automatically catastrophic for the economy the way it’s often portrayed. Sometimes, the effects of inflation can have a positive outcome – on both the economy and the stock market.
It’s a slippery slope the Fed must walk. If the inflation rate is too low, it can stagnate growth. If it’s too high, there’s a risk of stagflation – where prices rise but there’s little economic growth.
What do you think? Do you agree with the growing assertion that inflation could actually help jumpstart this economy? Or do you worry that the effects of inflation will not only hurt the economy, but eat into your investment returns?
Either way, I’d love to hear from you. Please email me at [email protected] with your thoughts.