Is Your Investment Portfolio Ready for More Inflation? Part 1

Low inflation has long been a thorn in the side of the U.S. and European central banking establishment. Even the mighty Federal Reserve has floundered in the face of persistently low inflation rates.

While the Fed’s multiyear struggle to juice up inflation may have seemed Sisyphean, the past few months have seen them bear fruit at last. Indeed, it is increasingly clear that inflation is back in force.

Facing the specter of deflation

Studies of the history of central banking are often preoccupied with the excesses of monetary policy, especially when they lead to runaway inflation. Yet in recent years, few of the developed world’s central bankers have shown much concern about the prospect of triggering such hyperinflation. Rather, most have been preoccupied with the looming specter of deflation.

A period of persistent deflation tends to dampen demand. The expectation that real prices will fall over time causes consumers and companies alike to delay purchases. This impact is magnified by the expectation of lower real future income, a result of the same deflationary pressure. An economy that finds itself caught in a deflationary spiral can struggle to get out. Japan, for example, has broken new ground developing a range of novel monetary policy tools in its decades-long effort to escape its deflationary quagmire, but to little avail. Japan’s difficulties have been an object lesson for other central banks, which have made avoiding a similar deflationary spiral a top priority.

The economic shockwaves brought about by the coronavirus pandemic last year served to further highlight the potential dangers of deflation. While some analysts fretted about the potential inflationary impact of the Fed’s unprecedented monetary interventions in response to the crisis, others were more sanguine. The editors of the Financial Times, for example, declared in April 2020 that deflation was still the bigger threat:

“Ask economists about the causes of inflation and ‘too much money chasing too few goods’ will be towards the top of the list. Coronavirus might seem to have delivered both parts of that cocktail: central banks have printed money, partly to finance government spending, while production of everything from cars to kitchen extensions has collapsed. Worries about inflation, therefore, are understandable. But they are misplaced: the world economy has more to fear from deflation...Deflation would make high corporate and government debt loads even harder to manage as interest payments stay fixed but wages, prices and tax payments all fall in cash terms. All this suggests that investors should prepare for another long period of miserable yields on government debt -- most likely below inflation.”

Rising risk of runaway inflation

Inflationary and deflationary pressures are often driven as much by market psychology as by policy. As inflation expectations rise or fall, economic actors’ behavior tends to shift in response. However, since differing perceptions and expectations will naturally color the responses of individuals, firms, governments and others, often leading to variegated responses, especially in the period immediately following directional shifts (inflation to deflation, deflation to inflation, etc.) and magnitudinal shifts (accelerating inflation, decelerating inflation, etc.) as economic actors work to make sense of a cacophony of market signals.

Inflation is a complex phenomenon impacted by a vast array of market and policy forces. Under the right (or wrong) circumstances, even a light nudge can set off an uncontrollable chain reaction. That prospect has caused a number of analysts to fret, especially as inflation has accelerated in the summer months. In May, Bank of America (BAC, Financial) chief equity strategist Savita Subramanian warned that rising inflationary pressure could well result in a period of hyperinflation:

"On an absolute basis, [inflation] mentions skyrocketed to near record highs from 2011, pointing to at the very least, ‘transitory’ hyperinflation ahead."

While the probability of the U.S. economy careening so rapidly from a near-deflationary environment to a hyperinflationary may not seem high on its face, it is not impossible in light of the imperfect, and often rather blunt, tools at the Fed’s disposal. The U.S. central bank does what it can to shape the financial landscape, but its weapons are limited, as are its powers of prognostication. Boston Fed President Eric Rosengren, for example, admitted last month that inflationary pressures were likely to continue beyond the central bank’s prior expectations.

Preparing your portfolio

With inflation edging up noticeably for the first time in years, capital markets are bound to be affected. Investors accustomed to an ultra-low interest rate environment may soon have to rethink their strategies and allocations. Much remains to be seen before investors can respond effectively to the evolving state of affairs. While no one can deny that inflation is back in force, the magnitude and persistence of that inflation remains far from clear.

How investors can prepare themselves and their portfolios for an uncertain future will be the subject of the second part of this series.