Despite uncertainty in the global economy, price data suggests inflation may be on the rise—a potentially worrisome development considering U.S. unemployment levels are still alarmingly high.
The world is undoubtedly more complicated since the onset of the coronavirus pandemic. And while it’s impossible to follow every story, investors and traders would be wise to keep an eye on the inflation narrative during Q1 2021.
Inflation is the economic concept that describes how prices tend to naturally rise over time in healthy economies. When prices for goods and services rise, so too does employee compensation and corporate profitability. In a capitalist system, those are generally perceived as desired outcomes.
Using a negative example for reinforcement, imagine that a company is forced to cut the prices it charges for its products by 25%. That’s probably not going to be a good thing for the company, nor its employees. Such conditions describe a deflationary environment, typically observed during a recession or depression.
In short, that means deflation is bad, and inflation is good.
The problem, however, is that too much inflation is also bad. For example, if the prices of goods and services are rising too much, consumers and businesses may struggle to keep up.
That’s why central banks, like the U.S. Federal Reserve, set inflation targets for the economy and use the tools at their disposal to manage toward them. Until September 2020, the Federal Reserve held to a stated inflation target of 2%. Theoretically, that meant if inflation levels were above or below 2%, the central bank would intervene in some fashion to help push inflation lower or higher.
However, last September, Fed leaders announced they were loosening their philosophical approach on inflation. In response to the coronavirus pandemic, the Fed decided it wanted to remove the near-term threat of higher interest rates, a common tool for fighting inflation, but also a potential dampener of economic growth. The intent was to inflate confidence in the future prospects of the economy.
To achieve this goal, the Fed made a small technical change to the way that it calculates inflation, essentially averaging it out over a longer period of time. In practice, that meant the appearance of rising inflation wouldn’t necessarily be met with a swift reciprocal rise in the short-term interest rates (i.e. federal funds rate) controlled by the Fed.
Instead, the Federal Reserve would monitor inflation—to ensure that any inflation increase above 2% was sustained—before ultimately raising rates.
While that policy approach sounds wonderful in theoretical terms, a growing concern in 2021 is that it will a lot be more difficult to implement on the ground.
The current economic situation is especially tricky because of the somewhat divergent impact of the coronavirus on the American economy. Much like the split personalities of Dr. Jekyll and Mr. Hyde, the pandemic has left some parts of the U.S. economy ravaged, and others mostly unscathed.
The concern at this time is that rising inflation could further exacerbate the hard realities of the economy. Rising prices, especially rapidly rising prices, could spell disaster for the vast pool of unemployed, and underemployed, workers in the U.S. economy.
A further breakdown in the current pandemic economy could result in complications not yet imagined, as well as additional bouts of social unrest—both of which could ultimately push the economy back into recession, or worse, depression.
Investors and traders would therefore be wise to monitor inflation going forward because any sudden, drastic changes could affect the stock market, as well as other asset prices.
Inflation can serve to push the values of stocks and commodities higher because there are more dollars chasing a fixed amount of goods and services. However, that positive can turn into a negative if inflation is too high, forcing the Fed to raise interest rates.
Even before the pandemic, the stock market got spooked when the Fed was slowly “normalizing” interest rates—attempting to bring the federal funds rate back toward 2%.
At this time, investors and traders need to keep in mind that the central bank is currently navigating uncharted waters. That became clear on Jan. 12 when the Institute for Supply Management (ISM) released data showing that an index measuring the prices paid for industrial materials jumped to nearly 78 in December, about 20% higher than the level observed in November (66).
The expectation prior to the release of the data was that the month-over-month change would be negligible. That surprising increase is the primary reason that close observers of inflation are now sitting a little closer to the edge of their seats.
Interestingly, data from Europe shows that inflation expectations are also shooting higher across the Atlantic. A metric widely followed by experts—the five-year forward inflation swap rate—recently spiked to a 12-month high in the Euro area.
The Fed, for its part, has reiterated it wants to see a sustained rise in inflation before raising rates. However, investors and traders won’t be completely comforted by those sentiments, given that the Fed can’t easily control how fast or how far inflation spikes—at least not without unwanted interest rate intervention.
To learn more about inflation, and whether owning gold can protect against it, readers can review a previous installment of Market Measures on the tastytrade financial network. To follow everything moving the markets, readers can also tune into TASTYTRADE LIVE, weekdays from 7 a.m. to 4 p.m. Central Time.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of Luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to firstname.lastname@example.org.