Inflation: Why is this such a big deal and how does it affect me?

Inflation is a term that has been dominating the financial news in recent months, and as investors, it is important to understand what the term inflation means and how it affects our investments.

Key Takeaways:

• Understanding inflation and its causes
• Central Bank responses to support economic growth have increased inflationary pressures
• How inflation can affect your investments
• How to best position your portfolio for an inflationary environment

Understanding inflation and its causes

Inflation occurs when demand for goods and services in an economy exceeds supply.  When this happens, prices for those goods and services rise.  When the supply of goods or services exceeds demand, prices fall.  Not all of this sounds that bad.  Strong demand for goods and services is a good thing, right?  Well yes, moderate inflation is a sign of a healthy economy because as an economy grows demand for goods and services increases.  Inflation encourages consumers to spend now instead of waiting for higher prices later and this encourages economic activity.  It is clearly a better scenario than consumers hoarding cash waiting for lower prices later (deflation).

Central Bank responses to create economic activity have increased inflationary pressures

What about the narrative that inflation is all due to the Federal Reserve’s “printing money” with the (QE) quantitative easing program?  

Let’s first explain what quantitative easing is and why the Federal Reserve is doing it in the first place.  When a central bank decides to implement quantitative easing, they make large scale purchases of financial assets from financial institutions (typically bonds, but can be stocks), and the increased demand for these bonds has the effect of lowering long term interest rates.  The lowering of long-term interest rates is expected to increase borrowing from corporations and consumers which ultimately spurs economic activity.

To understand how this increased money supply puts pressure on inflation I am reminded of my childhood days playing the board game Monopoly with my friends.  In many instances, we would mix things up and play a modified rules version of Monopoly where each player would receive more than the $1,500 in starting cash that traditional Monopoly rules mandated players start the game with.  This additional money caused changes in behavior for the players as this additional capital was being used to spend/bid on properties, where most players would be willing to pay much more than the $100 “list price” for Vermont Avenue.  This new “market price” above $100 for Vermont Avenue would indicate price inflation on the property that was caused largely due to the additional money supply for players of the game.

But the Federal Reserve’s quantitative easing program has been going on since the financial crisis, why haven’t we had material levels of inflation since then? 

Well, much of this has to do with human psychology.  The sharp decline in the value of investors’ portfolios during the financial crisis created a lasting impression on those that lived through it.  In our modified Monopoly example, the additional money that players had previously used to bid up prices on Vermont Avenue were now being saved in case of another future crisis.  Additionally, coming out of the financial crisis most banks still had troubled loans and assets on their balance sheets and used these funds from the Federal Reserve to shore up their balance sheets rather than creating new loans.  The result was that the additional money supply didn’t make it into the financial system therefore it did not affect the prices of goods and services.  The velocity of money, a measure of the amount a currency is used to purchase goods and services within a given period, reached an all-time low in March 2020.

How inflation can affect your investments

Investors are on alert as inflationary pressures can affect your investment portfolio in several ways.  Inflation means higher costs for corporations, and many companies may not be able to offset these higher costs with higher prices which ultimately impacts profitability.  Higher inflation could cause the Federal Reserve to remove its easy money policies sooner than previously anticipated, and stock market participants are concerned as this support has had a positive influence on equity prices.  Higher inflation causes bond yields to rise, which raises borrowing costs for companies, and given the inverse relationship of bond yields with bond prices this would be negative for those invested in bonds.

The Federal Reserve has stated that they believe that the recent acceleration in inflation will be “transitory”, that price increases caused by the economy’s reopening will soon abate.  August’s inflation reading that came in below economist’s expectations gave credence to the transitory inflation view, but the debate has not been settled and investors should be prepared for inflation to remain sticky above historical levels.

How to best position your portfolio for an inflationary environment

At Bouchey Financial Group, we are keeping a close eye on the data and are advising our clients to position their portfolios to mitigate the negative effects inflation can have on an investment portfolio.  We are advising our clients to tactically position portfolios toward areas of the market that have historically fared well during inflationary periods.  We have looked to de-emphasize investments in companies that show significant inflation pressure building from the cost side which will ultimately impact profits.  We have incorporated substitutes in place of bonds, which have a below average risk-reward outlook given the backdrop of low yields, tight credit spreads, and the high likelihood of higher interest rates given the inflationary pressures discussed.

If you have any questions regarding inflation or other financial-related matters, please feel free to contact our team for a discussion. We also recommend you check out our recent blog about the balancing act of bonds.

Bouchey Financial Group has offices in Saratoga Springs and Troy, NY.