Understanding the effects market forces can have on your investments is the first step in protecting yourself against potential adverse effects. To help you do that, we’ll take an in-depth look at one of the most commonly discussed market forces – inflation.
Inflation can be defined as either the general increase in prices over time or as the decline in purchasing power of a given currency. These are two sides of the same coin, as one causes the other. Inflation can be measured a lot of different ways depending what type of inflation is being analyzed, but the most widely accepted way to measure broad inflation is by looking at the increase in prices of a broad basket of consumer goods and services. The most common example is the Consumer Price Index (CPI), put out by the US Bureau of Labor Statistics.
In simple terms, inflation is caused by too much money chasing too few goods. The “too much money” part of that equation is what has inflation on the mind of many investors right now, which is understandable given how aggressively the Federal Reserve has been injecting liquidity into the system during the COVID-19 pandemic. The other part of the equation, “too few goods”, appears to be less problematic at the moment. Technology and globalization have been powerful countervailing forces in making it cheaper and easier to manufacture goods and provide services over the past couple decades.
Since the end of World War II, inflation has really only been problematic once: the stagflation era that lasted for most of the 1970s. The Federal Reserve policies implemented under Paul Volcker ended the stagflation era and changed the way we think about how monetary policy can and should be used to control inflation. Inflation in the US has been generally stable and at reasonably low levels since the early 1980s. Of note, however, is that inflation has been extremely low since the period preceding the 2008-2009 financial crisis, with the CPI averaging only about 1.8% per year. To the extent that investors and consumers have come to accept this lower level of inflation as the new normal, a return to higher levels of inflation that were previously understood to be acceptable may be difficult to digest.
For a deeper dive on the mechanics and history of inflation in the U.S., take a look at this article written by an economist at the Federal Reserve Bank.
In Part 2 of our inflation exploration, coming soon, we’ll take a look at how inflation can affect investment and some strategies to apply in an inflationary environment. In the meantime, don’t hesitate to contact us with any questions you have about this or any other market impacts.
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DISCLOSURE: Cobblestone does not provide tax or accounting advice; clients should also consult with licensed professionals in that field.
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