Inflation has been quiet for a very long time. In fact, other than periodic spikes in energy prices, inflation has been more a matter of speculation than reality. Prices have generally tended to be predictable and that’s been a benefit to both consumers and businesses.
But there some signs that inflation may be about to return. If it does, how should we prepare?
Why higher inflation may be on the way
Since the early 1980’s central banks all around the world have been working to squeeze inflation out of the economy. This collective policy has lead to a multi-decade run of disinflation. Disinflation is the process of lowering the rate of inflation, and since the policy was implemented, inflation has declined from double digits down into very low single digits. Sometimes it’s even bumped close to zero.
We could say mission accomplished! Unfortunately, economic prosperity is a dynamic, not a destination, and central bankers can rarely rest on past accomplishments.
One of the fears in recent years is that disinflation would eventually succumb to deflation, which is an entirely different and less holy outcome. Under deflation, wages, asset values and general price levels decline. While that may seem like a positive development, it’s actually a recipe for an economic depression. In fact it was the driving force that launched the Great Depression in the 1930’s. The problem with deflation is that it feeds on itself and turns ugly. That’s what central banks want to avoid.
There are now indications that central banks may be about to reverse course and let a bit of inflation into the mix. Inflation, it’s thought in certain quarters, might actually remedy what still ails the very sluggish economy.
Are we ready for the change?
Inflation and your income
This could play out one of two ways. If wage growth reacts quickly to higher inflation, consumers may be in a position to increase spending. That will increase demand and hopefully begin creating new jobs too. On the other hand, if wages continue to run behind the price curve, higher prices could quickly overrun salary increases. If that happens, the economy could slow even more.
We probably should expect the second scenario to play out. Unemployment remains uncomfortably high and that’s a doubtful starting point for higher wages. Now would be an excellent time then to cut living expenses in anticipation of higher inflation. In particular, we should be hesitant to take on any new expenses or financial entanglements, at least until we get a clear idea as to which way the wind is blowing.
Inflation and your debt
Inflation usually translates into higher interest rates. That makes a strong case for 1) locking in interest rates now while they’re still low, and 2) converting variable rate debt to fixed rate debt as soon as possible.
If inflation is coming, we should no longer bank on a continuation of the very low interest rates we’ve reliably had over the past few years.
Inflation and your mortgage
The prospect of higher inflation should be a siren call to refinance your mortgage now, if you haven’t done so recently. This may be your last chance to lock in the lowest mortgage rates in history. Throw the election in with the prospect of higher inflation and we could be looking at substantially higher mortgage rates a year from now.
Inflation and your investments
Since higher inflation will mean higher interest rates, the impact on your investments could be substantial.
Equities. Because interest bearing investments compete with stocks, rising interest rates may not bode well for stocks. Higher interest rates make fixed income investments more attractive. Alternatively, certain stock sectors, like resource stocks, may benefit from higher inflation.
Fixed income assets. This is probably not a good time to commit your money to a five- or ten-year certificate of deposit or Treasury note. You’ll be tying up your capital at very low rates of return while higher returns will be coming available. Money market funds and very short term securities may not pay much interest, but they’ll keep your cash free to take advantage of higher rates later.
Commodities. Energy in particular tends to benefit from inflation, but other sectors may present opportunities as well. Construction materials, precious metals and rare industrial commodities may benefit as well.
Will a little bit of inflation be a good thing for the economy?
Could inflation kick start the economy? Many experts believe that it will. Many of the problems that still plague the housing market could largely be solved with rising prices. Debtors in general would benefit as inflation lowers the value of their debts. And the anemic wage increases of the past few years might see some improvement too.
Of course, inflation isn’t all good news. The effect on interest rates will be a definite negative. And if inflation rises too quickly, it could cause all sorts of distortions that could make economic conditions worse.
What are your thoughts on inflation? Have we gone too far with disinflation—has it maybe even caused our economic problems? Do you think that inflation might be just what we need to fix the debt and real estate problems? Or do you think that inflation will take us down a dangerous path?