By Alex Kluesner
Governments around the world have made unprecedented efforts to support the global economy in response to COVID-19 by increasing spending and getting cash into the hands of both consumers and companies. Steps taken thus far may well have been necessary to help fight the pandemic’s economic fallout – but at what cost? Pundits are starting to point their collective finger at a dramatic increase in inflation, which is the idea that currency depreciates – buys less – as time goes on.
Is this specter real? Is a rapid post-pandemic rise in inflation worth fretting about? To start, it may help to keep in mind that inflation in and of itself isn’t something to fear, and that your long-term plan was designed to anticipate such events. But let’s begin answering these questions by viewing today’s low inflation in its historical context.
Many of you remember periods of high inflation in the mid-1970s and early 1980s that stemmed from a brutal combination of expansionary monetary policy, a Middle East oil crisis, and full departure from the gold standard. The Federal Reserve was forced to aggressively tighten standards and raise interest rates into the double digits.
Expansionary monetary policy alone doesn’t guarantee higher inflation. For inflation to increase, the money supply and/or rate at which it’s spent must rise as well. In the 1970s, banks and consumers used a bigger money supply to make loans and seek more goods and services. American Nobel Prize-winning economist Milton Friedman would describe this phenomenon simply as “too much money chasing too few goods.”
Fast-forward to today. We’ve been living in an extended period of low relative inflation. From January 2010 to March 2020, the U.S. has been at or above the Fed’s targeted 2% inflation rate only 8.9% of the time. That’s just 11 months of the last decade. But trillions of dollars have entered the money supply. Surely, we are past due for periods of high inflation like the 1970s?
In fact, there are a few key differences about today’s economic environment that suggest quite the opposite. First, many Americans are saving any financial aid they might receive, rather than spending it, because their employment future is too uncertain. Second, U.S. Gross Domestic Product (GDP), which is a measure of all goods and services produced domestically, contracted in the first quarter of 2020, with further decline expected to come. This means real economic output is forecast to lag potential economic output more widely. The opposite would need to occur over a sustained period to force inflation higher. Even though anything is possible, especially in today’s uncertain environment, the market’s near-term inflation expectations are still low.
Perhaps the most important thing to remember is that our portfolio construction process takes many inflation scenarios into account. Your plan is built to protect you against these and other maladies that may harm your portfolio, as well as to afford you the best odds of achieving your most important life and financial goals.
Inflation is most risky to the bonds in a portfolio because of how they are structured and valued. For most conventional bonds, the periodic payments that investors receive are fixed at a certain amount and frequency over a predetermined length of time. As a result, inflation poses a greater risk to bonds with longer maturities. We typically limit maturities to 10 years or less and reinvest proceeds into new bonds at higher rates that have already adjusted to new inflation levels.
Trillions of dollars have entered the economy both directly and indirectly. But that doesn’t translate into increased inflation today or even necessarily in the years to come. As time goes on, we will get a better idea of how the economy has grown and how that affects prices. Until then, rest assured that we are keeping a watchful eye on the markets, so you can instead focus on what really matters to you.
Source: Federal Reserve Bank of St. Louis IRN-20-576