December 31, 2021

Writing in the NY Times Business section¹, Jeanna Smialek provided a brief yet thorough treatise as to what causes inflation and how it might affect us over the near term. Considering that articles about inflation have been widespread of late, it might be useful to understand how it might impact both your purchasing power and portfolio.

What causes inflation? “In the short term, high inflation can be the result of a hot economy – one in which people have a lot of surplus cash or are accessing a lot of credit and want to spend. If consumers are buying goods and services eagerly enough, businesses may need to raise prices because they lack adequate supply. Or companies may choose to charge more because they realize they can raise prices and improve their profits without losing customers.” When COVID struck, a lot of manufacturing facilities closed, and reopening them has caused supply chain problems as they attempt to ramp up production. The combination of limited supplies and pent-up demand by consumers have also contributed to significant price increases. (It’s the classic Supply and Demand curve from Economics 101.) The auto industry is just one example; not only did a computer chip shortage crimp production, but consumers rushed out to buy cars.

Where is inflation headed? There is some speculation among economists that inflation will slow as supply lines become more efficient, with more goods on the shelves leading to lower prices. While labor costs have gone higher for both blue and white-collar jobs, many of those pay increases have been factored into pricing. It’s unlikely that labor rates that quickly moved to $15-20/hour will take another dramatic leap anytime soon. While it’s likely that inflation will slow, there’s always the possibility that rising prices will force still higher labor costs (followed by even higher prices), a cycle that never ends well.

Is inflation bad? The answer depends on where you sit. For retirees on fixed incomes or families with modest incomes, low inflation means dramatically smaller losses in spending power. (Loss of spending power is ultimately the true definition of inflation.) If you’re an investor, retired or otherwise, low inflation also results in less income on the bond side of a portfolio. When publicly traded companies borrow money to expand, they sell bonds to investors to raise capital. Low inflation means low interest rates to those bond-holders, and it’s those bonds that comprise the bond funds in portfolios. Higher inflation would translate into additional income. In that regard, modest inflation would be welcome for investors. Even if you’re a wage earner who just had a significant increase in hourly wages, you’re still ahead if the increase in your salary exceeds the increased cost for goods that you buy.

How does inflation affect the stock market? Through the end of November 2021, the rate of inflation was 6.8%, the highest rate in almost 40 years, driven mostly by increased labor costs and a supply shortage. In response, the stock market has continued it’s steady upward march, assuming supply shortages will be eliminated and labor costs will mitigate.  Of course, if the rate of inflation doesn’t slow, the outlook for the stock market could turn down. “Really high inflation typically spells trouble for stocks…Financial assets in general have historically fared badly during inflation booms…Companies that lack pricing power – meaning they cannot easily pass costs on to customers – suffer the worst, because they are forced to absorb input cost increases by taking a hit to their profit margins.” Obviously, we’ll learn a lot more in the months ahead.

¹ Smialek, Jeanna. “Explaining Inflation: Effects on the Economy Are Stark and Nuanced.” The New York Times, 24 Dec. 2021.

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