Inflation is defined as the rate of price increases on goods and services in the economy. Inflation can occur for a number of reasons.

What Causes Inflation?

Inflation can have many causes. It might be a function of changing prices for ingredients or raw materials that are used to produce something. This might be a food product, or it could be an industrial component. Manufacturers will typically pass along increases in their costs to the consumer of the product to the extent that they can. Rising interest rates can increase borrowing costs for companies, this is a cost they will pass on to their customers if they can as well.

Monetary Policy

The Fed’s monetary policy is currently centered around keeping the federal funds rate near zero with a goal of keeping inflation around 2% over the long run.

There has been some concern from investors in recent weeks as the rates on the 10-year Treasury bond has creeped up a bit. Their concerns center around whether these rising rates are a signal of rising inflation. While the rising rates are not an actual indicator of rising inflation, they may be a sign that investors are anticipating a rise in inflation. Fed Chairman, Jerome Powell indicated recently that he has not seen broad signs of inflation at this point.

Analysts have mixed feelings about where we are headed. There is sentiment that increases in the rate on the 10-year are a result of economic growth plus the impact of the recent stimulus bill.

Role of the Federal Reserve in Combating Inflation

Arthur Bass, Wedbush’s Managing Director, Fixed Income Financing, Futures, and Rates says, “ It has now been a year since the Fed reduced its fed funds target range to 0-25 bp at the start of the Covid pandemic. The Fed has also been purchasing $120 billion per month in Treasury and mortgage securities and has sponsored numerous other programs to provide stability to financial markets.

These efforts have been successful in helping the economy weather the Covid shutdowns and dislocations. With the success in vaccinations and recovery in many sectors of the economy, there is now increasing attention on when the Fed will move short term rates off of the zero lower bound. These concerns have increased since the passage of the $1.9 trillion stimulus plan, on top of the $600 billion stimulus plan passed in December. While 2-year yields are little changed since the start of the year due to expectations the Fed will remain on hold, 10 and 30-year yields are about 75 bp higher as the yield curve has steepened.”

Bass adds, “The key to whether the Fed’s projections adjust to the market’s or vice versa will depend upon the continued growth in the economy and realized inflation. Thus far, inflation indices have not reflected much price pressure, although a number of economists feel that CPI has been held back by the owner’s equivalent rent portion.

Upcoming inflation numbers are expected to rise, and the Bloomberg Commodity Index rose 48% in the past year due to the strength in housing and several resource shortages. Monthly inflation indices turned negative for the first few months of the lockdowns a year ago, which will boost year over year comparisons. Fed Chairman Powell has mentioned these potential increases and has already termed them transitory.

With fixed income investors fearing over-stimulation, the next several inflation releases will garner more than the usual amount of attention. The other major factor influencing interest rates will be the progress in developing an infrastructure plan and how it is financed. Longer term interest rates will most likely rise further if a good portion of the plan is not financed with other revenues and if it is pushed through in the same manner as the $1.9 trillion stimulus plan, through reconciliation.”

How Stocks Respond to Inflation – Potential Impacts on Valuation

While stocks are generally considered a hedge against inflation, the impact on stock prices has historically been mixed. Rising inflation can impact the ability of consumers to spend as their real purchasing power is reduced. This potentially could be a negative for stocks that depend on consumer purchases.

We’ve seen recent rises in commodity prices, notably oil which has been reflected in rising prices as the gas pump. As the economy heats up, we may see both increases in inflation and interest rates. Some businesses will have trouble passing along the entire impact of these factors in the form of price increases. This could hurt the profitability of some companies and be reflected in their stock price. This could have a ripple effect on stock valuations, or at least change the sectors that exhibit market leadership in the future.

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