Inflation refers to the declining purchasing power of money over time, caused by a general level of rising prices. In an economy with a 2% annual inflation rate (the favored figure for the US Federal Reserve; see NY Times article cited below), items that cost $10,000 today would have cost $5,000 36 years ago, using that 2% rate. This also means that for people with life expectancies of 36 years, for every $100,000 accumulated currently, you need to have that amount grow to $200,000 just to be able to buy the same items. If inflation rose 4% per year, then prices would double every 18 years, making it much more difficult for investors to keep up (the $100,000 investment portfolio would have to grow to $400,000 just to stay even over the 18-year period). Financial markets in stocks and bonds provide a way to increase assets in excess of inflation.
It is important first to note that no investment result caused this erosion in purchasing power. Rather, central banks seem to have determined that a growing economy can absorb some price inflation, that 2% is a reasonable figure, and that zero inflation would signal an economy in recession. So it is the rising prices in the economy at large that create inflation. In a recent NY Times article discussing the possibility that years of low inflation and low interest rates may be coming to an end, Neil Irwin writes that “if this really is the start of a resetting of inflation and interest rates toward more historically normal levels, it will be mostly good news for the world economy. Central bankers have spent years trying unsuccessfully to get inflation to the 2% level many of them aim for.”
There is a close and direct connection between inflation and interest rates (and changes in bond prices, which are determined by changes in interest rates). Here’s why: a bond is a promise to repay a fixed amount of money in the future, plus interest (think of a bond as an IOU from a company or governmental entity). If the purchasing power of the money received in the future is going to be lower than when the bond was purchased (the definition of inflation), then the interest payments received must at least cover the loss of purchasing power. The interest payments then need to provide some positive investment return above the rate of interest paid to cover the inflation rate.
To put this idea into figures: if inflation is 2%, the interest you earn on your bonds needs to be greater than 2% to allow for some increase in purchasing power when the bond matures and the bond investment money comes back to you. And the longer the maturity of the bond, the higher the interest rate needs to be to compensate the investor for the current risk of future purchasing power. It is less risky to wait two years for the return of money from a bond investment than it is to wait for ten years, which is why interest rates on longer maturity bonds are higher than on short maturity bonds. And when dealing with money markets and other short-term, bond-like investments (e.g. bank CDs), whose interest rates often fall below the inflation rate, investors should be aware they are trading price stability of the investment for declining purchasing power over time.
In the current economic environment, central banks such as the US Federal Reserve (the “Fed”) set the overnight interest rates they control to accomplish a balancing act: keeping rates low enough to encourage economic growth, yet high enough to discourage too much growth, which in turn would give rise to inflation. In this context, inflation means rising prices (the same rising prices that translate into declining purchasing power). Accomplishing this balance is complex and delicate. The current Fed is trying to raise rates from the ultra-low rates in place since the 2008 recession, to more historically normal rates based on inflation of 2% (see Neil Irwin quote above). Every time the Fed raises rates by 25 bp (1/4 of 1%), the other outstanding bonds traded in the financial markets react, typically through declining prices, so that the lower interest rate associated with these outstanding bonds provides the same investment return at maturity as a newly-issued bond with a higher interest rate. It is always unclear ahead of time how many rate changes the Fed needs to make to have the interest rate level at an appropriate place, neither too low nor too high.
The effect of inflation on stock prices is not nearly as direct as with bond prices. Higher prices often mean more profits for businesses, but higher interest rates increase their expenses. Higher interest rates also negatively impact purchasers who need to finance their large economic transactions, like buying a home or a car. Further, if inflation gets too high, many people are not able to afford the transactions at all, which has the effect of slowing down economic activity. As Irwin writes in his NY Times article cited above, “If higher interest rates are caused by higher economic growth, that’s a dynamic stock investors would probably be fine with, in that more growth should translate into more corporate earnings. But if the higher rates are being driven by inflationary pressures, that’s a different story, and suddenly the assumptions behind sky high stock prices could fall into doubt…. In the short run, markets can be shaped by all kinds of things, whether algorithmic trading or a run of bad news for a major company or a presidential tweet. But in the longer run, economic fundamentals are powerful forces.” What the article leaves unsaid, and what is always difficult to determine in advance of the event, is whether the higher rates are driven by good economic growth or not-so-good price inflation.
From an investment standpoint, higher rates make bonds more attractive, which could draw money away from the stock market. Irwin’s article also makes reference to this point: “After nine years of economic expansion and rising stock prices, the stock market is richly valued relative to earnings, making the earnings return on the stock market low. That low return might be tolerable when money invested in an ultra-safe Treasury bond or even in a savings account, generates very low returns,” but as those short-term rates rise, they become more attractive investments to some group of investors looking for safety of their capital, which has the potential of putting downward pressure on stock prices.
As stock and bond prices fluctuate more significantly, inflation will often be used as an explanation. An example is the recent NY Times article on jobs growth (front page, 5/5/18), discussing the low unemployment rate combined with a lack of rapid wage growth, which states that “Hourly earnings went up by 2.6% over the past year, not much faster than inflation. The subdued wage gains eased the prospect that the Fed would accelerate its plans to raise interest rates.” In any case, inflation is and will remain an important factor in the movement of stock and bond prices.