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Inflation’s Deflating Effect on Stocks

No Free Lunch With Looser Credit, Increased Government Spending

As unemployment increases and retail sales falter, the threat of inflation isn’t getting much attention. Instead, the government is focused on trying to stimulate spending as a way to end the recession. Using the primary tool at its disposal, the Federal Reserve has kept the federal funds rate between 0 percent and 0.25 percent since the end of 2008. By comparison, the rate was 5.25 percent in summer 2007, before the meltdown in the subprime mortgage market and the subsequent credit crisis.

Perhaps the most immediate effect of the Fed’s decision is the reduced rates on conventional mortgages available to borrowers with high credit scores. In many areas of the country, those rates are lower than they’ve been since 1965, according to Freddie Mac. Car dealers are offering even lower rates — though sometimes with strings attached — to get moribund vehicle sales moving.
But even with the added liquidity that low rates provide, there’s been relatively little economic growth. One reason is that people concerned about losing their jobs are reluctant to make major financial commitments, including
discretionary or large purchases. Similarly, businesses that may be able to borrow more cheaply, or hire talented workers more easily, than they could six months ago
may be reluctant to expand when the timeline for an economic recovery is uncertain.
Meanwhile, if the Fed’s looser credit policy works — and we have to hope it does — the downside is that it could kick off a new inflationary spiral.
The spiral typically works like this: On the consumer front, increasing demand for a range of products would drive prices up because months of production cuts have reduced supply. On the business side, the increased costs of adding new employees and new equipment to meet demand would result in higher prices for new products. More problematic, an expanding economy typically increases demand for energy, which can ratchet up costs across the board.

Inflation and Your Portfolio

As if paying more for almost everything weren’t enough, rising inflation can also create problems for your stock portfolio. An old rule of thumb is that when inflation threatens, stock prices suffer.
One explanation for falling stock prices in an inflationary period is that interest rates also often inflate as the Fed tightens the money supply to rein in borrowing. When the rate investors can earn on insured bank CDs is high enough, they tend to move out of stocks and into CDs. The thinking is that there’s no reason to risk losing principal when you can realize a higher return with no risk.
In addition, investors may be concerned that the higher earnings companies report in inflationary periods may result from artificially high prices rather than productivity gains. In that case, investors may be unwilling to pay the current price for the stock or, if they own it already, decide it’s time to sell. Similarly, if they sense that inflation is getting out of hand, they may anticipate that the Fed will reverse course and tighten its credit policy. In that case, companies that have become too dependent on easy credit are likely to lose traction as borrowing becomes more expensive. As their expectations falter, their stock prices are likely to fall.

The Deficit and Stock Prices

Another, more serious threat to stock prices may be the increased federal deficits that result from the programs designed to jump-start the economy and put more money into circulation. To meet its obligations, if the Treasury needs to raise rates on its issues to attract investors, those higher rates will attract money that might otherwise have gone into stocks, pushing equity prices lower.
At the same time, if unemployment remains high, the country could witness a replay of the stagflation — high inflation in a stagnant economy — that plagued the United States in the 1970s and early 1980s. In 1980, for example, the inflation rate topped 13 percent — more than 10 percentage points above the historical annual average of 3 percent.
Yet as concerned as stock investors may be about prospective inflation, it pays to remember that the early 1980s were followed by the longest bull market in U.S. history. Although this isn’t a prediction of what may happen over the next few years, history may provide some assurance that stocks have the potential to rebound even from the toughest times.

Virginia B. Morris is the Editorial Director for Lightbulb Press.

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