inflation target

The Inflation Powder Keg

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A few weeks ago, the Federal Reserve issued a policy statement greenlighting more interest rate hikes despite fears of inflation.1 For years the Fed has struggled to keep inflation up to its target rate of 2%, and now that it is there, it looks likely to us that the Fed may overshoot the target entirely.

Interest rates and inflation tend to go hand in hand. When interest rates are high, borrowers can earn more money to spend, creating upward price pressures. When inflation is high, lenders try to raise rates to keep ahead of inflation. As rates continue to rise, you can often expect inflation to do the same.

Worse, there are other pressures looming on the horizon that we think may contribute even more to inflation. A strong economic cycle and robust jobs market may often bring higher inflation. As unemployment drops, workers become harder to find. Many companies might have to offer higher wages to get the employees they need, forcing them to raise prices—at the same time that workers have more money to spend from higher wages. Rising prices and rising wages equals inflation.

We also expect more price pressure to arrive from overseas. The trade war that the current administration seems bent on fighting shows no signs of cooling off. When you raise taxes on a product, such as a tariff on imports, inevitably the price may go up to pay for the taxes.

Tariffs create knock-on effects, as well. Many products manufactured inside the U.S. use materials imported from overseas that are subject to tariffs, so domestic products may also face rising prices. And domestic companies that are fortunate enough to dodge the tariffs entirely may still raise their prices opportunistically: with the prices of other goods rising, they have an opportunity to increase prices and profits without hurting themselves as much competitively.

Once again, where you have rising prices, you have inflation. Put it all together and the economy may be sitting on a powder keg of explosive inflation pressure. We do not know when or if the powder may exploded, but we cannot afford to ignore it.

We have gotten so used to low inflation rates in the past decade that it is easy to pretend they will last forever. Sooner or later, we expect some investors to be burned by this mindset. We want to do what we can to avoid being among them. Clients, if you have any concerns about how inflation may affect your portfolio or investment strategy please call us.

Notes and References

1:Press Release, Board of Governors of the Federal Reserve: https://www.federalreserve.gov/newsevents/pressreleases/monetary20180613a.htm. Accessed June 28, 2018.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

 

Burning Up Money

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No doubt you probably noticed the turmoil in the stock market over the past several weeks. You might have assumed, if you watched the stock indexes hit a low of more than 10% below their peak, that some particularly ugly piece of news had hit the market.

If so, you would probably be surprised to hear that the biggest news stories leading to the correction were that the economy was booming and unemployment was at record lows. So why were investors panicking at this seemingly positive news? The answer is inflation.

You see, as the economy grows, increasing wealth leads to increasing demand. This means higher prices–or, in economic terms, inflation. This creates a couple of problems for the stock market. In the long term, rising prices make it harder to maintain economic growth and may contribute to an eventual crash. In the short term, both economic growth and inflation increase the pressure on the Federal Reserve to raise interest rates, making bonds and other interest-driven investments more attractive relative to stocks.

We are deeply skeptical of this short-term rationale. While bond investors may salivate at the prospect of higher interest rates in the future, we think this is short-sighted. Tomorrow’s higher interest bonds may sound attractive, but you would be foolish to buy them if the interest rate is going to be even higher the day after. On February 5th, when the stock market was posting headline-grabbing declines fueled by interest rate paranoia, investors were actually buying up bonds–bonds that stood to lose purchasing power as soon as better, higher interest bonds started being issued!

The longer term concern, that inflation may spell the beginning of the end of the current economic boom, is a bigger threat. We have warned for a long time that the Federal Reserve was likely to wind up overshooting the mark on its 2% inflation rate target. We think this is even more likely now that the government has passed a very stimulus-minded tax package. Cutting taxes during the middle of a boom is likely just throwing gasoline on the fire: it is possible we may see some explosive growth, so in the short run we are excited about the market, but in the long run the economy may just burn out that much faster.

Clients, many of you have been in business with us long enough to remember the roller-coaster years we saw around 2007. The dip at the start of February may potentially be forgotten as the market forges on ahead, but it will not be the last one. The roller coaster is coming back, and although we look forward to the ride we will keep a mindful eye for the day we may need to think about getting off. Call us if you have any questions about the market and the broader economic outlook.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

All investing involves risk including loss of principal. No strategy assures success or protects against loss.

A is A

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At the height of ancient Greek civilization, the philosopher Aristotle taught the Law of Identity. A is A. Everything has a single identity, not two or more, and two different things do not share the same identity. A is A. A dog is not a cat; an orange is not an orangutan, an olive is an olive.

One wonders what has been lost through the centuries, when considering Federal Reserve Bank policy. The Fed, as it is known, is charged with a dual mandate. It is supposed to promote maximum employment and stable prices.

If Aristotle were alive today, he might teach that stable prices are stable prices. This would be in accordance with the Law of Identity. A thing is what it is. Yet the Fed has adopted a 2% inflation target, supposedly in accordance with its mandate of price stability1.

At 2% inflation, a dollar today buys only 98 cents worth of goods next year and about 96 cents the year after. Prices would double every 35 years or so, under this inflation target. Over the course of a century, a dollar would shrink to about 12 cents in purchasing power. In what sense is this ‘price stability?’ It violates the simple precept that Aristotle taught 2,300 years ago.

One error some people make is presuming the things we can measure are important, and the things we cannot measure are unimportant. Higher dollar volumes of activity are presumed to be good. So when productivity or technological improvements reduce prices of things we purchase and use, we are obviously better off—but conventional economic statistics may indicate otherwise.

There are ramifications for us as investors. The threats to our prosperity from inflation may be discounted by the Federal Reserve. The advantages of technological progress are understated. We think this means we need to be more sensitive to the damage that future inflation might do to our wealth, and the opportunities presented by technological progress.

Clients, if you have any questions about this or any other pertinent topic, please email us or call.

1Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/faqs/economy_14400.htm


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

The opinions expressed in this material do not necessarily reflect the views of LPL Financial.

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

This is a hypothetical example and is not representative of any specific investment. Your results may vary.