Inflation may not be “as frightening as an armed robber,” as Ronald Reagan once said, but its likely return to financial markets, after more than a decade of steady-to-declining prices, may come as a bit of a surprise.
A recent analysis from BCA Research makes the case for why inflation likely is set to pick up “modestly” over the next few years, then spike sharply mid-decade.
“Nevertheless,” wrote Peter Berezin, BCA’s chief global strategist, “the risks are skewed toward an earlier and sharper increase in inflation in the U.S.”
What exactly does that mean? Here are a few key takeaways from Berezin’s analysis.
Inflation is certainly going to rise briskly in the next few months. That’s because prices cratered last spring when the coronavirus-crisis erupted. Since inflation data is expressed as year-over-year changes, prices will register a bigger increase in the next few months than we’ve been used to seeing. Most investors generally expect that “base effect” and will largely look through it, except that:
Inflation may cause some headline risk that leads to choppiness in the markets. Also, as Berezin points out, inflation can be “a self-fulfilling prophecy.” By his thinking, “If households expect prices to rise and then keep rising, they may try to expedite their purchases. This would supercharge spending,” he wrote. “Imagine last year’s Great Toilet Paper Shortage but on an economy-wide scale.”
A similar phenomenon can play out in the corporate sector. If firms expect prices to keep rising, they may hold on to some of their inventory until they can get higher prices for the goods, which will limit supply, driving prices higher.
“Inflation expectations” may sound a bit flimsy, but, Berezin points out, it’s one of the Federal Reserve’s most important tools right now. In August, the central bank said it would aim to achieve an average of 2% inflation. That means that in order to offset years in which inflation ran below that target, we should expect that the Fed will tolerate some period of inflation over that benchmark before interest rates are increased to try to rein it in.
Since a big concern about inflation for investors is that it often prompts central banks to tighten, the new policy should put investors’ minds at ease, Berezin noted. “In and of itself, inflation is not necessarily bad for stocks,” he wrote, though there are steps investors should take, including reducing fixed-income duration and opting for value stocks over growth names. There are some signs that investors are already jockeying for inflation positioning.
What Berezin does not address, however, is how consumers will manage rising inflation. If the price of gas, lodging, and food surge, that likely crimps consumer discretionary spending quickly.