Economy

In One Sense, Inflation Isn't Coming: It's Already Here. What That Means for Investors

Federal Reserve - Shutterstock photo
Credit: Shutterstock photo

It is extremely rare these days to hear people talk of inflation as if it is a problem. If anything, it is now seen as a desirable thing, as a sign of a strong economy. That is the inevitable product of a few decades when rising prices haven’t been an issue in the world’s major economies, and it could well be true if it is demand for goods that is causing prices to rise. However, there is evidence that another kind of inflation is already taking hold in America, and it may not be as desirable and controllable as the Fed seems to think it will be.

The Fed is still pumping money into a recovering U.S. economy, even as vaccinations bring a probable end to the pandemic in sight. Interest rates have recovered somewhat, but are still well below historic averages, and some kind of fiscal stimulus is about to be added to the mix. I know that the economy is still weak and ordinary people are suffering, but all of that could have big inflationary implications. The Fed must know that too, but it seems they don’t care.

Actually, they do care, but not in the way you might think. St. Louis Fed president James Bullard was on CNBC this morning, saying that overshooting their long-time two percent inflation target would be a good thing. His argument was that after a falling short of that target for a decade or so, a period of exceeding it would help to bring the long-term average of inflation back to two percent.

I have a great deal of respect for Bullard and have no doubt he is a lot smarter than me, but history tells us that that is an extremely dangerous argument to make.

It rests on the assumption that inflation can be easily controlled once it takes hold, an understandable thing for a modern central banker who has never seen the corrosive impact of inflation, but that assumption is not one supported by evidence. History is littered with examples of fiscal and monetary authorities around the world who thought a little inflation would be a good thing, only to find out too late that it was a tiger that is uniquely hard to tame. I understand that modern central banks believe they have a deeper understanding of inflation than their predecessors and have tools to deal with it that didn’t exist in the past, but then those that unleashed the tiger in the past did so because they believed exactly the same thing.

The outward manifestation of inflation is higher prices for goods, but often the root cause of it is the other side of the pricing equation, the value of money itself. As more and more dollars are put into circulation, the intrinsic value of each one is gradually reduced. We can see that happening now as the relative value of alternative currencies takes off. Whether you are talking in the conventional sense and looking at the steady decline in the dollar index, or the less conventional and looking at the rise of bitcoin and other cryptocurrencies, the dollar has been losing intrinsic value for some time.

Nor is it just currencies where that decline in the dollar’s value is evident.

PDBC chart

Commodity prices, as represented by the commodity ETF (PDBC) shown above, have bounced back strongly and are now above pre-pandemic levels. Most people tend to think it is demand for commodities that push prices up, but sometimes it can be that the thing the goods are priced in, U.S. dollars, are losing relative value. Given that the world is still recovering from a massive shock to global growth and is not back to the levels of a year ago, it is unlikely that demand alone has pushed commodity prices above where they were at that time.

So, if you think of inflation in terms of relative weakness in the value of a currency rather than of relative strength in the value of goods, you could argue that we are already experiencing inflation, and it is just a matter of time before that is reflected in the producer and consumer price indices that most people use to measure it.

That has implications for investors.

If prices are rising because of intrinsic dollar weakness, the price of everything, including stocks, will rise. Inflation, therefore, is not a reason to sell stocks at this point, it is quite the opposite; it is a reason not to. In that context, stock valuations can’t be judged by conventional metrics, so shouldn’t be a worry for now. In theory, when the dollar weakness begins to show as price increases throughout the economy, every company will make more money as prices rise, so the average market P/E will adjust.

Of course, there will also be a concurrent rise in costs for those companies, so it won’t turn out well eventually. For now, though, inflation is actually the investor’s friend and will remain so as long as the Fed continues to encourage it.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Martin Tillier

Martin Tillier spent years working in the Foreign Exchange market, which required an in-depth understanding of both the world’s markets and psychology and techniques of traders. In 2002, Martin left the markets, moved to the U.S., and opened a successful wine store, but the lure of the financial world proved too strong, leading Martin to join a major firm as financial advisor.

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