Higher prices are clear to see, but equities shrug off inflation concerns

As published in the Minneapolis Star Tribune 7/17/2021.

Defining inflation is easy enough: It’s what happens when things become more expensive than they used to be. Measuring inflation and its effect on financial markets is not as straightforward.

The inflation numbers you hear about most usually refer to the Consumer Price Index (CPI), which measures the change in prices of consumer goods and services compared with the previous year. Last week, Department of Labor data showed that the CPI increased 5.4% in the last 12 months, the most significant rise since 2008. The last three months have seen year-over-year increases of 4.2%, then 5% and now 5.4%.

Inflation, in other words, is here and it’s accelerating.

Chances are, you already knew that. Maybe you haven’t tracked CPI figures every month, but you’ve noticed your favorite restaurant raised the prices on its menu. Or you raised an eyebrow when you saw the selling price of a neighbor’s house.

Anyone who shopped for a used car recently can attest that inflation matters. Used vehicle prices jumped more than 10% in the last month alone, and that’s before you fill the tank with gas that is 45% more expensive than a year ago.

In our case, replacing a fence in the backyard led to the realization that 4×4 cedar posts cost $40 each. Lumber prices more than tripled from last summer until May 2021, then promptly fell 50% in recent months (unfortunately, not until after the fence was completed).

The point is that inflation hits and feels a little different for everybody. The stock market, meanwhile, does not interpret inflation the same way consumers do. The S&P 500 has gained roughly 15% since early March when inflation data began ramping up. That’s a good thing for anyone invested in equities, but it can be difficult to understand.

Higher costs, for one thing, are not entirely bad. It’s a sign of financially healthy consumers being willing and able to spend more dollars. With consumer spending constituting the largest slice of the U.S. economy, the silver lining becomes more obvious.

The more important factor for investors is how rising inflation will ultimately affect Federal Reserve policy, which remains the largest short-term influence on asset prices. Fed Chair Jerome Powell has insisted that rising inflation will be “transitory,” meaning higher prices are the result of pandemic-related supply shortages rather than longer-term cyclical forces.

Powell’s “transitory” label is somewhat of a brilliant cop-out. The suggestion that higher inflation won’t be with us forever justifies the Fed’s inaction and cannot be proven wrong any more than a weather forecast predicting a 50% chance of rain. Inflation pressures will eventually subside. Whether that happens in three months or three years matters a great deal but one could still consider them temporary (or transitory) either way.

The big question on Wall Street: When will the Fed feel enough pressure to raise interest rates or begin tapering its bond buying? Both would represent a hurdle for stock prices. The good news is that neither appears imminent. The Fed’s preferred measure of inflation, core Personal Consumption Expenditures, shows less severe increases than the CPI, and consensus estimates suggest no Fed rate increases until 2023.

In the meantime, the market has been willing to focus on the positive aspects of inflation rather than the costs. Inflation, it seems, is in the eye of the beholder.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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