Economy

What is Inflation, and is it Good or Bad?

Men looking at stock quotes at Nasdaq MarketSite
Credit: Reuters / Gary Hershorn - stock.adobe.com

Inflation is a term that has been dominating the news, and as an investor, it is important to understand how the term is used and what it means for your portfolio. Following announcements of price increase and reports of supply chain problems from a growing number of companies, the subject has become one of renewed interest.

On May 12, Consumer Price data came in at a stunningly hot pace, well above already elevated expectations. The headline number came in at 0.8% MoM, which was quadruple the expected 0.2% increase. On May 13, we learned U.S. producer prices for April increased at twice the expected rate, rising 0.6.% MoM and 6.2% YoY, the largest YoY increase since 2010 and well above the expected 3.8% increase.

Clearly, these are big numbers. But not very helpful for those who don't know exactly what inflation really is. Here we'll take a look at exactly what it is, and how (and why) it affects stock prices.

The funny thing about the term inflation is that it is widely used as if there is one universally accepted meaning for it, but its meaning is about as varied as the word "love." While I love both In-N-Out’s double-double animal style, and my family, the two sentiments really aren’t the same. I can’t do without In-N-Out.

One version of the term "inflation" refers to when the overall demand exceeds supply in an economy. This is also referred to as the “output gap” by economists. When this happens, prices rise. Conversely, when there is more supply than demand, prices fall. Keep in mind that the growth of supply of goods and services in an economy is a function of the growth of the labor pool and productivity.

But what about all this “money printing” we keep hearing about, with the Federal Reserve’s quantitative printing? Wasn’t that supposed to cause inflation? This refers to economist Milton Friedman’s rather famous assertion that inflation is “always and everywhere a monetary phenomenon.”

To understand what this means, picture an island economy that has just 100 $1 bills. A mischievous fellow named Ben from a neighboring island flies over this island and drops an additional 20 $1 bills one evening. The amount of goods and services hasn’t changed, but now with an additional 20% more dollars available, the price of things is going to go up, probably.

There is a catch here.

What if those 20 $1 bills landed in Sally’s lap and she decides to just hide them in her mattress? While technically the supply of money has increased, a decrease in the “velocity” of money perfectly counters the increase in money available. This is why, despite the incredible increase in the money supply since the Great Financial Crisis, we haven’t had material levels of inflation. The velocity of money has been declining since 1997 and reached an all-time low in March 2020.

There are some other variations of inflation but these are two of the main versions. The thing is, trying to convince an economist in the first school of thought that inflation is a monetary phenomenon is about as effective as trying to convince an Italian that pineapple is a legitimate pizza topping. It’ll never work, so don’t bother.

This brings us to the stock market. Why have stock prices reacted negatively to signs inflation might be heating up? Following that red hot CPI data release, the equity markets took a serious beating Wednesday, with the Dow falling 2.0%, the Nasdaq Composite 2.7%, and the S&P 500 2.1%.

Equities aren’t happy about rising inflation pressures for multiple reasons. With markets flirting with all-time highs, the risk-to-reward tradeoff in equities skews more toward downside risk:

  • Higher inflation means rising input costs (the cost of creating a product or a service; think materials or labor) that may not be able to be offset by higher prices.
  • Higher inflation could pressure the Federal Reserve to scale back its easy-money policies sooner than expected; the stock market isn't a fan of this idea because easy money policies have helped drive the markets to these recent highs we have been seeing.
  • Higher inflation pushes bond yields up, which means higher borrowing costs. Given that we have a record-high level of corporate debt, that is big deal.
  • Companies with high growth rates, such as many of those in technology, get hit harder when interest rates rise since higher rates reduce the current value of future earnings.

The bottom line is inflation could be a headwind.

That said, when we dissect the April CPI report, it appears to be more bark than inflationary bite. Less than 5% of Wednesday’s CPI categories were responsible for the vast majority of the index’s increase: 10.2% of the 11.6% annualized. The other 95% of categories added just 1.4% annualized, well below the Fed’s 2% target. In other words, only a small handful of categories were responsible for this inflationary "jump." The categories that were stoking the inflationary fires were hotels, auto rentals, and used-car prices, which are unlikely to continue to see such extreme price spikes, so it isn’t time to worry just yet.

There are other reasons to not worry.

Recall that first definition of inflation is in which demand rises beyond supply. Today’s economy continues to have high levels of unemployment amidst rising productivity levels, and capacity utilization levels that are well below peak. That means there is plenty of room in the economy to boost supply. Domestic manufacturing capacity utilization was 73.8 in March, which was not only down a few ticks compared to year ago levels, but also well below the 1988-1989 and 1994-1995 peaks that ranged between 84.6-85.5.

It is going to take time to sort out global supply chains that were seriously shaken by alternating lockdowns and re-openings. As Atlanta Fed President Bostic put it, he “expects a lot of noise in inflation data through September.” If the data continues to run hot through June, we’ll revisit these inflation concerns, but for now we are going to put the panic button back in the drawer.

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

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Lenore Elle Hawkins

Lenore Elle Hawkins serves as the Chief Macro Strategist for Tematica Research. With over 20 years of experience in finance, her focus is on macroeconomic influences that create investing headwinds or tailwinds. Lenore co-authored the book Cocktail Investing and in addition to her Tematica work, provides M&A consulting services for companies in Europe looking to expand globally. She holds a degree in Mathematics and Economics from Claremont McKenna College, an MBA in Finance from the Anderson School at UCLA and is a member of the Mont Pelerin Society.

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