Inflation in the economy is like watering down coffee. The dollar becomes worth less and less potent as inflation increases. Despite that, inflation is a necessary part of a growing, stable economy that helps incite and suggest aggregate demand growth.
Does that mean eventually gum will be $100 a pack? Theoretically yes, but it’s more likely the currency or country itself will be supplanted long before then. Governments try to manage inflation through monetary policy, ideally keeping it around 2% annually.
The effects of inflation combined with what the Fed decides to do through its monetary policy both come together to drive some, if not most, of the broader sentiment surrounding the stock market. A contractionary monetary policy or rate hikes can send investors running for safe havens, while lower rates generally contribute to expectations of economic growth.
How it actually works: Anything can happen
The stock market is like one giant Rube Goldberg machine that tries to accomplish one thing through an innately over-complicated method. It’s an emotional being that contradicts itself at times, meaning that any irrational behavior can ironically be rationalized by playing the “markets are irrational” card.
We like to think low rates generally equate to growth and optimism in the market, right? Insert a pandemic and some irrational inflation fears to go with it, and you can then explain away why the last few months haven’t exactly been pleasant for a lot of sectors.
Anything can happen, and anything can be explained given the right combinations of variables. All of our rules and generalities are nothing but approximations.
Our current situation
- Rates are low (0.00-0.25%) and expected to remain there for the near term future, with any concerns about rate hikes all having been put to bed for now.
- Comparing April 2021 with one year ago, the CPI indicates inflation to be up about 4.2%. It rose 0.8% in the month of April alone, and consumer spending was up 0.5% from March.
- The broad CPI doesn’t tell the whole story though. The energy index is up 25.1% over the last 12 months, used cars were up 10% in April alone and 21% in the last year, and obviously fuel is up substantially considering the low demand at this point last year.
- Both the Dow and the S&P held ground in May, each turning up just a bit green. The Nasdaq lost a hair but came out clean, and the RUT tacked on just 17 points. Overall, you could say the markets seem to be mulling it over and standing pat for the moment.
And all of this means?
Some investors are fearful that inflation will outrun itself with rates this low for too long, or that it could eat into both the future earnings and input costs of the businesses they’d like to invest in. On the optimist’s side of things, they see the inflation as proof of and reason for recovery from the pandemic, and this along with increases in vaccinations is helping to incite hope across sectors.
That means, anything is possible and we can’t predict how the markets will react to inflation data or monetary policy at any given time. At best, we can forecast a bit and invest wisely into things that fit our criteria.