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

The remarks, which had been anxiously awaited all week, sparked an initial reaction to sell stocks that quickly reversed itself. Later in the session, stocks again fell, as investors’ expectations for a rate rise later this year climbed. Treasury yields and the dollar also fluctuated before rising.

Loose U.S. monetary policy has been a driving force in financial markets, keeping the dollar soft and supporting stocks and bonds.

Will higher rates kill the current stock market rally? Despite the apparent fear and trepidation of the market, the Fed is likely to raise rates by another tenth or two tenths of a percent. A little historic perspective on interest rates is in order.

Effective Fed Funds Rate

It has been since before the 2008 market crash that the effective Federal Funds Rate was been anywhere but near zero. However, the Federal Funds Rate has been as high as 19.4% in July of 1981. Courtesy of the Federal Reserve Bank of St. Louis here is a chart showing the Effective Federal Funds Rate going back to 1955.

The federal funds rate is the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight.
The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.

The Federal Open Market Committee meets eight times a year and determines a federal funds target rates which it aims for by buying and selling government bonds. As the graph shows, the historic oddity is the fact that rates have been near zero for eight years! Although high interest rates can hurt the economy we are usually talking about the rates seen in the 1970s. The economy was doing fine in the late 1990s even though the Federal Funds rate was in the 5% range.

Winners and Losers, What and When to Buy

Utility stocks will take a hit on the threat of an interest rate rise as noted by Investor Place.

There’s no arguing that utility stocks have knocked it out of the park this year. Year to date, the Dow Jones Utility Average (DJU) is up better than 18%. Utility stocks are always attractive to income oriented investors because of their dividend yields. But is now the time to buy?

Probably not. In fact, I recently recommend taking profits in utility bellwether Southern Company (SO). But it looks like investors will get an opportunity relatively soon to pick up some high quality names in this dependable, dividend paying sector.

And there likely will be bargains to be had for those looking for secure retirement investments after these dividend stocks over-correct. Dividend stocks are normally considered an alternative to bonds but now days when interest rates are nearly zero dividend stocks are a better bet. Smart investors will wait for a slight correction and then add to their buy and hold portfolio. If rates go too high that could be another issue but look at the Federal Funds Rate graph for a little perspective.

When Yellen Speaks Stocks Fall PPT

The Federal Reserve is widely expected to raise interest rates next month, a move that some worry would make it harder for the central bank to achieve its goal of 2 percent inflation.

Wall Street says worry not: A newly released survey of the nation’s biggest bond dealers suggests Fed policy will be easy for years, even after a series of rate hikes.

The results show that primary dealers believe the neutral rate-the borrowing cost, adjusted for inflation, that keeps the economy at full employment with stable prices-is currently around zero, and will rise more or less in a straight line to 1.5 percent by the end of 2018. Compare that with the Fed’s own projections of where interest rates will be (adjusted for projected inflation) over the next few years.

How fast interest rates will rise will depend on the U.S. economy but the consensus of bond dealers is that we will see a slow and steady increase up to no more than 1.5 percent in the next three years.

Interest Rates and Stocks

When rates go up will it be good or bad for the stock market? According to The Wall Street Journal stocks have rallied recently based on a possible rate increase.

U.S. stocks rallied Wednesday after minutes from last month’s Federal Reserve meeting showed most officials anticipated economic conditions could be strong enough for a December interest-rate increase.

Major indexes posted their biggest one-day gains in nearly a month. The Dow Jones Industrial Average rose 247.66 points, or 1.4%, to 17737.16. The S&P 500 rose 33.14, or 1.6%, to 2083.58, and the Nasdaq Composite climbed 89.19, or 1.8%, to 5075.20.

“I think it’s a relief for the market that in the opinion of the Fed policy makers the economy is not falling apart,” said Keith Bliss, senior vice president at brokerage Cuttone & Co.

Financial stocks rallied, as higher rates can boost banks’ profits because they can widen the difference between what banks charge on loans and what they pay for deposits.

As the article notes, banks will benefit from higher rates. Another factor is the uncertainty that has affected markets for a year and a half as this issue has been on the table. The fact that rates will in all likelihood rise slowly and not very far seems to have reassured investors.

Utility Stocks

Last week we wrote that it is time to sell utilities. The Street differs. Their view is that utilities offer yield with safety for the conservative investor.

Utilities are in a class by themselves. They’re known for their higher-than-average dividend yields and lower than average stock volatility. There are a number of relatively safe utility stocks (i.e. low betas, meaning low stock volatility) that offer dividend yields in the neighborhood of investment-grade bonds, while offering potential stock returns as good as or better than the S&P 500 stock index.

The specific utilities mentioned in the article are NextEra Energy, Idacorp, Excel Energy, DTE Energy, Dominion Resources and Brookfield Infrastructure Partners. Our suggestion is to consider how fast interest rates will rise, wait for utilities to take a hit when the Fed raises rates and when buy when prices are depressed. As always do your own homework before investing.

How Fast Will Interest Rates Rise? PPT

The focus remained on central banks. The Federal Reserve’s October meeting concludes on Wednesday, with expectations for a rate rise this year having faded in recent weeks.

Uncertainty over the timing of an increase in U.S. rates is adding to investors’ cautious stance this week, said Christophe Donay, chief strategist at Swiss investment firm Pictet Wealth Management. “The bulk of the rebound is behind us. The Fed’s exit strategy remains a concern and is still ahead of us,” he said.

Investors were also looking ahead to the meeting of the Bank of Japan on Friday, at which the central bank could announce further stimulus measures. Robin Brooks, an analyst at Goldman Sachs Inc. is forecasting “substantial” easing by the central bank.

Currencies gained 0.2% against the dollar at $1.1043. Following the ECB hint at further stimulus, many analysts are forecasting a further fall in the single currency.

Global stocks rallied at the end of last week after the European Central Bank hinted it could expand its stimulus plan for the economy in December. Investors’ appetite for equities was further bolstered Friday by a rate cut from China’s central bank.

Every move by every Central Bank is analyzed for its potential to drive markets up or down. What will central banks do next is equal to quarterly financials as a predictor of the market.

What Does the Future Have in Store?

Fortune predicts an epic rally of the markets in an article laying our four reasons to be optimistic.

The truth is, global central banks are in control. They have been coordinating since 2009 to save the worldwide economy from an apocalyptic spiral. Because the crisis was global, and the structural problems remain highly intertwined globally, the only hope toward achieving a return to sustainable growth was through a coordinated effort to restore stability and confidence. And with that backdrop, they had to create incentives for people to take risk again. It has worked!  With the Fed moving closer to exiting emergency policies, this past year, the QE baton has been passed from the Fed to the ECB and the BOJ.

In short the author is saying that the actions of the Fed to rescue the US and global economy have worked and the finishing touches are being put on by other central banks. If that is the case what will central banks do next? They will probably continue easing until that policy is no longer needed and then go back to their usual tasks of controlling inflation.

Will the Fed Raise Rates Now?

The Washington Post writes that the Fed will not raise rates in October although there is no assurance that they will before the end of the year.

Here are five charts that explain why it’s safe to bet the Fed will pass on raising rates this week. Sure, there will likely be at least one key official who will argue that the time to act has already passed. But there is growing doubt, both inside and outside the central bank, that the economy will be strong enough to stand on its before the year is over. This week’s gathering appears to merely be a staging ground for the real battle in December, the Fed’s last meeting of 2015.

The Fed will raise rates when the economy is strong enough and there is a risk of inflation. By the time that happens it should be apparent to everyone.

What Will Central Banks do Next? PPT