Inflation keeps popping up in economic news these days. An uptick in inflation is to be expected in the time of strong economic growth we are currently experiencing, but this uptick comes after a long period of very subdued inflation, so it feels out of the ordinary. Let’s look at a history of inflation, talk about the forecast going forward, as well as how it could affect you as an investor.
History of inflation
To start, inflation is an increase in prices of goods and services, with a fall in the purchasing power of money. Official inflation tracking in the US dates back to 1913. Over the years, inflation has been as low as -10.8% during the Great Depression years and as high as 18% in 1946. These two time periods represent a period of deflation and hyperinflation, respectively. Inflation typically increases when the economy is growing strongly (often during and after a war) and inflation typically decreases during a time of slow economic growth (think 2010 through 2019). Inflation can also increase when the supply of key inputs to the economy is restricted (like the oil embargo in the 1970s). Since the early 1990s, inflation has been historically low and held more constant, averaging in the 2.4% range in the US 1990 to 2020.
Forecasting inflation for 2021
Why all the news lately regarding inflation? Late 2020 through today, the US economy has experienced stronger economic growth than we have seen since 2009 after the Great Recession. Annual GDP growth in the US was forecasted to be about 4.0% in January of this year. As of the end of June, that forecast is now at 6.2%. Inflation is following right along with it – forecasted to be 2.0% at the beginning of 2021, that number now stands at 3.35% as of the end of June.
In the June meeting of the Federal Reserve, the Board agreed to keep the federal funds rates as is and indicated it would likely do so into 2023. The federal funds rate is the rate banks charge each other to borrow. The reason that this rate is important is because the Federal Reserve will use this rate as a tool to slow down or speed up the economy as needed. At this point, the Fed is not worried enough about inflation to attempt to slow down the economy.
When the Federal Reserve met in June, they used the term “transitory” when discussing higher recent inflation. Over the long term, inflation is still low. The Fed thinks the current increase in inflation in 2021 is due to transitory factors. For example, inflation was low in 2020 due to the pandemic. The Consumer Price Index rose just 1.2% for the full year. However, due to fiscal policy (huge government spending to counteract the effects of the pandemic), supply chain disruptions, and material shortages, inflation is picking up more rapidly in 2021. The Fed believes that the pace of economic growth could slow down late this year into 2022. Relying on that view, they have decided to keep interest rates low for at least the next year.
How does it affect us as investors?
Inflation affects investors in two primary different ways. First, if you are a fixed income investor, stronger inflation typically means that the Fed will increase interest rates in the broader economy and you will earn a decent return on fixed investments. However, since we not seeing the full effects of inflation and the Fed is keeping the federal funds rate low, we will continue to see poor interest rates on CDs, savings, and money market accounts. If you are a stock investor, higher inflation generally correlates with strong market growth. If you are a borrower, lower inflation means you can take advantage of lower interest rates. When inflation actually picks up, the rates for borrowing will follow.
It’s normal to be concerned about rising inflation, and 2021 has served up some inflation numbers that we haven’t seen in decades. But, for now, strong economic growth, and leftover supply bottlenecks from the pandemic, explain the recent surge in inflation quite well. Predictions that the recent inflation increases will be transitory still make sense to us. We remain of the view that inflation over the next ten years is likely average 2-3% annually.
Sources: Investment Strategy Quarterly, July 2021. Wall Street Journal, July 11, 2021. Higher Inflation is Here to Stay for Years, Economist Forecasts. Bureau of Labor Statistics. Bls.gov
Any opinions are those of Jennifer Adams and not necessarily those of RJFS or Raymond James. Expressions of opinions are as of this date and are subject to change without notice.