Cheering Inflation

Story Highlights:

• In January, consumer prices rose a slightly higher than expected 0.3% from the previous month
• Mild inflation is a positive sign companies are gaining some pricing power and the economy isn't slipping into a deflationary spiral.
• Despite the massive amounts of liquidity being supplied by central banks around the world, problematic inflation levels are way off if they ever surfaces at all

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Today was a disappointing day for investors capping an even more disappointing week that left global equity market hovering near their November lows. But the day wasn't entirely bereft of good news. Today's ray of sunshine came from a rather unusual source—higher than expected inflation data. Today's report on the US consumer price index (CPI) showed prices rose 0.3% in January from the previous month. That was a bit higher than the expected 0.2% increase. And believe it or not, rising prices can be good.

It isn't often investors find solace in higher inflation. In fact, it wasn't long ago concerns about run-away inflation in the US and overseas was a primary concern. But economic conditions have changed rapidly over the last several months, and deflation is now perceived as the greater risk.

It's true inflation erodes the value of money, but higher prices aren't all bad, especially when compared to deflation. Moderate inflation provides an incentive for people and business to purchase goods and services since they'll cost more in the future. Deflation has the opposite effect, creating a disincentive to buy. Mild inflation also benefits borrowers by reducing the real interest rates (that's interest rates less the rate of inflation) on fixed-rate loans. Deflation makes borrowing more expensive in real terms.

The wall of money the Fed is injecting into the financial system is intended to not only stoke the economy and get credit markets working, but also stave off deflation. Inflation and deflation are monetary phenomena, but money from the central bank doesn't immediately impact prices. The velocity of money (the number of times money is spent) is a key factor in transmitting liquidity created by central banks to the broader economy (remember Irving Fisher's famous equation: MV=PQ). Robust banks lending increases the velocity of money, while constrained lending causes the velocity of money to plummet. Credit markets are slowly making progress, but the velocity of money remains well below normal levels. So more money from the Fed isn't yet translating into significantly higher prices.

Other factors such as capacity utilization, productivity, and employment also affect inflation. And those measures aren't pointing to rampant price increases anytime soon. At some point down the road, conditions will change, and the Fed and other central banks will have to reign in some of the liquidity they've created or risk undesirable levels of inflation. But even if they fail to do so properly, uncomfortably higher inflation won't rear its head overnight. On the contrary, the risk is probably years away.

Elevated but reasonable levels of inflation can actually benefit stocks, whereas fixed income investments often suffer in this environment. Rising prices give companies pricing power and often enables then to improve their margins. By contrast, fixed income investments often suffer when inflation elevates. Not only is the real value of coupon payments (again, bond coupon rates less the rate of inflation) reduced as inflation rises, but bond prices fall as rising interest rates accompany rising prices.

Given the fact so many have feared deflation, today's news should be a silver lining in another volatile day.