Investors worry so much about inflation because it can kill their returns

A woman looks up as snow begins to fall in front of the New York Stock Exchange, (NYSE) during the morning commute in New York City, U.S., February 7, 2018.
Brendan McDermid | Reuters
A woman looks up as snow begins to fall in front of the New York Stock Exchange, (NYSE) during the morning commute in New York City, U.S., February 7, 2018.

For much of the last decade, investors were worried that inflation was too low. Now, they're getting spooked by signs that the pace of wage and price gains is picking up again.

The latest data on consumer prices is only going to stoke those fears.

On Wednesday, the government reported that U.S. inflation at the consumer level rose much more than expected in January, fueling fears that inflation overall is about to pick up again to potentially dangerous levels. Stock prices beat a hasty retreat.

The latest read on the consumer price index shows that it jumped 0.5 percent last month, surpassing economists' forecasts for a 0.3 percent increase. Taking out the prices of food and energy, which can swing widely from one month to the next, the index was up 0.3 percent compared with forecasts for 0.2 percent.

The news follows a report earlier this month that showed a strong pickup in wage gains, another inflation barometer. It was the biggest jump in more than eight years.

That brought the recent, seemingly relentless, bull market in stocks to an abrupt halt. After several pullbacks, the S&P 500 stock index had shed roughly 10 percent in a matter of days. Before Wednesday's report, it had climbed back to levels about 7 percent lower than the all-time high hit Jan. 26. But the CPI news sent investors fleeing stocks again.

Bond investors have also been on high alert for rising inflation. Yields on the benchmark U.S. 10-year note recently shot up to a four-year high.

Here's why investors are so spooked.

Weren't investors not that long ago worried about too little inflation? Why the switch now to worrying about too much?

Very weak inflation is a sign of a weak economy, and after the Great Recession, the great fear was that the economy would slip back into recession. For a time, there was a good reason to worry that as the global economy tried to get back on its feet, deflation might take hold.

Deflation is more than just low inflation. Rather, it is when prices start falling and then don't stop, which means companies make less money and have to pay workers less. When those consumers have less and less to spend, companies have to cut prices further and the cycle continues.

So a little bit of inflation is a good thing. It's a sign the economy is growing at a healthy pace. That's why the Federal Reserve has been working to set its interest rate policy with a target inflation rate of about 2 percent.

What do interest rates have to do with inflation?

Generally, lower rates tend to spur economic growth because they make money cheaper for companies and consumers to borrow and spend. That borrowing and spending increases demand, which tends to drive prices higher. The reverse has also been true in the past; when inflation heats up, higher rates tend to cool it off.

The best example in modern history was the Great Inflation of the 1970s, when wages and prices began rising uncontrollably. Several presidential administrations tried, and failed, to contain it. It wasn't until the Fed jacked up rates, twice, to double digits in the early 1980s that inflation finally subsided.

So why are investors so worried about inflation in the first place?

Investors in financial assets like stocks and bonds are always worried about inflation, because it erodes the buying power of whatever money they make on those investments. If you make 3 percent on an investment, but inflation is also at 3 percent, your real return is zero. The other reason is that higher inflation usually brings higher interest rates in response, from both the Fed (which sets short-term rates) and the bond market (which governs long-term rates.)

Since that early 1980s surge, interest rates have been on a long-term decline, with ups and downs along the way. That gradual decline has boosted economic growth, along with stock and bond prices, with two notable pullbacks in 2000-01 and the Great Recession. Now, nearly four decades later, the U.S. economy continues to grow, albeit slowly, and stock and bond prices have continued to rise.

But after pushing rates down to zero to repair the damage from the Great Recession, the Fed has made it clear that over the long run, interest rates are heading back up. So a reversal of that long-term, beneficial trend of falling rates could now slow the economy even further and hurt investments in stocks and bonds.

A lot depends on how aggressively the Fed moves to raise rates. With a new chairman, Jerome Powell, just installed in the job and inflation perking up, investors aren't sure he'll be able to take the same gradual approach seen during the tenure of his predecessor, Janet Yellen.

Why do higher rates hurt investments? Don't you get a higher return with higher rates?

Higher rates do make newly issued bonds more attractive to investors, but they make existing bonds less attractive. That's why there's a difference between the yield on an investment like a bond and the rate it pays (sometimes called the coupon rate because you used to clip paper coupons from the bond and send them in to the issuer for payment).

Here's how it works. Say you buy a newly issued, $1,000 bond with a coupon rate of 2 percent. You'll get $20 a year until the bond expires or you decide to sell it. But if rates go up to 3 percent, those new bonds are now paying $30 a year. If you to sell your 2 percent bond, the buyer is going to offer you less money for it to make up for the cash return they'll give up by not buying a newly issued 3 percent bond.

Warning: here comes the math. To make up for the lower coupon rate, the market price of your 2 percent bond falls to $666.67. That's because $20 represents a 3 percent yield on $666.67, so the new buyer is now getting the same yield as a newly issued bond. But you lost a third of your investment.

What about stocks?

Higher interest rates hurt stocks in different ways. Ironically, those higher yields on bonds tend to attract investors looking to avoid the risk of stocks to move more money into the safer returns from bonds. (Remember: if you hold a bond until it expires, you don't lose your original investment.) When money shifts to bonds, that lower demand for stocks weighs on share prices.

Stocks also trade largely on corporate profits, and higher rates tend to cut into profits because they increase the cost of money. If the underlying reason for higher rates is inflation, rising prices and wages also increase a company's costs, which further erodes profits.

All of which is bad for stock prices. Inflation is measured in a number of ways by various government agencies, and as long as the economy continues to expand it will be a consideration for markets.


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