Under (Inflationary) Pressure

With April’s inflation report nearly out, folks are debating how the economy (and the Fed) may respond to pressure from rising prices.

April’s inflation report hits later this week, and most expect a fairly sizeable jump. You’d think this would be a relief to all the folks fearing too-low inflation—“lowflation”—in recent months, but humans are a fickle bunch—it now appears folks fear higher inflation will upset markets. Why? Higher inflation could inspire a rate hike sooner than the Fed projects. While we have our doubts one month’s price increase means much for Fed policy, in our view, the whole exercise is a touch misplaced. With the yield curve steeper and lending accelerating, inflation probably does tick up over the foreseeable future. But this is a healthy side effect of faster money supply growth—generally good for the economy. At some point, rising inflation will prompt the Fed to tighten, but as long as policy is right for the economic conditions at hand, there isn’t any reason it has to be bad for markets.

Those who fear a big, near-term inflation jump forget a simple truth: Inflation is always and everywhere a monetary phenomenon. When considering inflation risk, many forget the money supply and look instead at certain components—if their personal cost of living is jumping, then inflation must be, too. This has driven a whole host of misperceptions about what triggers inflation. For example, food prices appear set to rise, worrying the many who think foodflation is a leading indicator. Never mind that (potentially) rising food prices are largely a function of a nasty drought in one part of the country. Others point to items like housing costs, rent, import prices and apparel (in addition to food) inching up. Some folks expect medical care costs to rebound, now that the sequester isn’t weighing on public health care spending anymore.

All of these are very visible costs—things that impact everyday life—and it’s natural to interpret rising prices in these categories as inflation. But inflation and cost of living are two different things. Inflation is an average of all prices across an economy. Food, health care and housing prices are only small pieces of the CPI basket. What matters more, for monetary policy purposes, is how prices move for the totality of goods and services. Higher grocery, medical and rent bills may pinch, but if they’re the only things going up at a brisk pace, that isn’t inflation.

Not that higher inflation isn’t around the corner. We don’t expect it to skyrocket—not with money supply growth just now inching up—but inflation has been below its long-term average (3%) for over two years, due largely to a drop in the velocity of money. The Fed started tapering its quantitative easing program, which should boost velocity some moving forward, as banks start lending more. But that won’t happen overnight. It takes time for money to work its way through the whole economy, and net interest margins are only just now responding to the steeper yield curve. Some point to improving employment as a near-term trigger, based on the long-running assumption tight labor markets drive up wages and prices in a vicious spiral, but decades of data have disproved this thesis, showing no consistent link between employment and inflation.

Even if inflation notched up to moderate levels, the economy wouldn’t suffer. Moderate growth and moderate inflation have gone hand-in-hand historically—rising money supply is the fuel for growth in our capitalist economy, and modestly rising prices are a sign that money is working its magic. The Fed has no incentive to keep this from happening—there is a reason its long-term target is a 2% core inflation rate.

No one can game how the Fed will respond to rising prices—human decisions aren’t market functions. That said, historically, the Fed looks for signs the economy is overheating when debating rate hikes, which today, are largely absent, and they look far beyond CPI. They look at growth trends both nationwide and in their own districts, money supply growth, lending, trade and many other indicators. If April CPI jumps, it seems a fair bet the Fed will discuss it at their month-end meeting. But they might very well look at the weak year-over-year comparison (CPI had a one-off fall last April) and chalk it up as a blip, not a trend-starter. Whenever a rate hike happens, it won’t be because a single economic measure hit some arbitrary threshold or because of Fed jawboning. And it won’t be automatically bad for stocks, either, considering history shows no correlation between interest rates and stocks. Investors who are getting their feathers ruffled over a potential initial rate hike are likely premature and fearing a false factor.

Today, investors should keep in mind inflation is very tame—and that’s a positive! But slightly higher inflation, for a month or longer term, wouldn’t be a worse scenario. It’d simply mean money supply and velocity are picking up from rock-bottom levels—a positive. More importantly: Low or moderate inflation during steady economic expansion—once dubbed a Goldilocks scenario—is a sweet spot for stocks.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.