What Does Increasing Inflation Mean for Stocks?

Prices of goods and services are inching up and according to The Wall Street Journal the Fed is not going to get in the way of a little inflation.

Inflation has begun picking up, and it looks as if the Federal Reserve is going to let it keep climbing.

The Labor Department on Tuesday said that consumer prices rose by 0.3% in September from August, putting them 1.5% above their year-earlier level. With gasoline prices stabilizing, annual inflation ought to push above 2% on the year within a couple of months.

Core prices, which exclude food and energy costs, have been there for a while. Last month they were up 2.2% on the year.

The worry on the mind of Wall Street for the last couple of years has been that in order to stay ahead of inflation the U.S. Federal Reserve will start raising interest rates and high interest rates would hurt stocks. It appears that the Fed might not be as worried about inflation as we all thought. Assuming that the Fed does not raise rates very fast and inflation goes up, what does increasing inflation mean for stocks?

How Inflation Affects Stocks

The effect of inflation on stocks is that profits and prices eventually decline. Investopedia discusses inflation’s impact on stock returns.

Rising inflation has an insidious effect: input prices are higher, consumers can purchase fewer goods, revenues and profits decline, and the economy slows for a time until a steady state is reached.

This negative impact of rising inflation keeps the Fed diligent and focused on detecting early warning signs to anticipate any unexpected rise in inflation. But once the unanticipated inflation works its way through the levels of economy, the impact of a higher steady state of inflation can have varying effects. In other words, the unexpected rise of inflation is generally considered the most painful, as it takes companies several quarters to be able to pass along higher input costs to consumers. Likewise, consumers feel the unexpected “pinch” when goods and services cost more. However, businesses and consumers eventually become “acclimated” to the new pricing environment, and then even when a new higher steady state is reached, the expected inflation that may occur thereafter can result in consumers spending more cash. These consumers become less likely to hold cash because its value over time decreases with inflation. For investors, this can cause confusion, since inflation appears to impact the economy and stock prices, but not at the same rate.

Those who gained adulthood in the 1970’s remember going Target to buy garden supplies in the fall because the same supplies were going to be much more expensive in the spring. Inflation is disruptive on several levels. The end result at the end of the 1970’s was called stagflation in which the economy stagnated along with stock prices while the cost of living kept going up. When inflation is a dominant factor companies quit hiring to save on salaries which retards growth. This was the stagflation effect that the Fed is usually concerned about. The problem today is that the Fed is so worried about choking off the recovery that they are probably going to wait a bit longer. This generally heartened the market as the immediate effect of higher rates is a drop in stock prices.

What Does Increasing Inflation Mean for Stocks? PPT

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