INFLATION AND THE FINANCIAL MARKETS
As the financial media continues to stress the role of inflation in the financial markets, we will discuss this topic of inflation here in the US. The Ibbotson 2020 SBBI (Stocks, Bonds, Bills, Inflation) Yearbook describes inflation as “the rate of change of consumer goods prices,” with the figures coming from the US Department of Labor, or DOL (pages 3-13). The Consumer Price Index (CPI), used by the DOL to measure US inflation, is made up of “a basket of consumer goods and services that are comparable but not identical” (Ibbotson, pages 1-12). The higher the rate of inflation, the more US dollars are needed to purchase the comparable basket of goods and services; this is referred to as a “loss of purchasing power.” The Federal Reserve Board (“Fed”) attempts to maintain the rate of inflation at acceptable levels, which the Fed has described as 2% annually, by adjusting the short-term interest rates it controls. It is sometimes, but not always, successful in doing so.
The connection between inflation and interest rates is key to understanding much of what happens in the financial markets. Investors seek to make investments whose returns will exceed the rate of inflation; otherwise, the investors lose the purchasing power of their money as time passes. Interest on bonds is one major source of investment return for investors looking to reduce their risks from far more volatile investments such as stocks and real estate. If the rate of inflation goes to 2%, bond investors will expect more than 2% from their investments, to cover the rate of inflation and provide what is referred to as a positive “real”, or inflation-adjusted, rate of return.
That still leaves open the question of what makes inflation rise. The current chain of events to higher consumer prices likely includes some combination of: 1) rapidly increasing economic activity, as the impacts of the pandemic are reduced; 2) US government programs that put money into the hands of people most adversely affected by the pandemic; 3) the need for the government to print more money and increase its deficit spending to provide such relief; and 4) supply shortages encountered by businesses attempting to meet the reviving demand from consumers.
If the financial markets anticipate higher prices (that is, more inflation), one reaction is to push up interest rates to cover the higher rate of inflation. This is what has occurred recently, as longer-term interest rates set by the buying and selling of bonds (using the ten- year US Treasury as the benchmark) have risen from historic lows of approximately 0.50% in the summer of 2020, as the pandemic continued to spread with accompanying sharply curtailed economic activity, to 1.75% at the end of March 2021. And while receiving more interest is good news for investors, in order to receive the full benefit of the rise in rates, the prices of existing, lower-interest rate bonds need to decline to provide an acceptable combined level of interest and price change to maturity (referred to as “total return”).
Inflation’s impact on stock prices can be seen as follows: if higher inflation drives up interest rates, and higher interest payments make bonds a more attractive investment, those higher rates can reduce the amount of money available for stock investing. While the long-term historical outcomes for stocks have been favorable and are mostly a function of the profits generated by the businesses in the economy, the daily pricing of stocks creates a great deal of volatility.
To get a sense for how long the annual rate of inflation causes prices to double, take the rate and divide by the number 72. Two percent inflation would lead to prices doubling in 36 years, compared to 3% inflation, which would cause prices to double every 24 years. This same “Rule of 72s” can be applied to annualized investment returns; 3% would double money every 24 years, while 5% would double money every 14-15 years. These considerations lead investors to take more risk for more return.
While these April Comments are meant to have a cut-off as of the end of April, it is worth noting that the NY Times (5/13/21, front page) reported that the CPI “climbed 4.2% in April from a year earlier… the fastest pace in a decade… even though Fed officials said the numbers reflected pandemic driven trends that would most likely be temporary.” Neil Irwin followed up with another NYT article (5/14/21, page B3) observing that “The central fact of the American economy in mid-2021 is that demand for all sorts of goods and services has surged, supplies are coming back slowly…and the question is whether current circumstances will make inflation less than temporary.” Since inflation is such a major story for the financial media and in the political arena, we will follow this closely in the coming months. April’s stock and bond results were both positive, even with the inflation story much more visible.
FURTHER COMMENTS ON BITCOIN
Bitcoin continued to rise in price through April, and public interest has grown accordingly. We will pass on discussing the complex technology, called blockchain, that underlies the creation of Bitcoin. We focus instead on whether Bitcoin is likely to gain the status of money/currency, as a recognized means of exchange, which in the long run is likely to determine whether its current pricing is simply a speculative trading bubble.
Bitcoin started out selling at one unit for a few hundred US dollars as a trinket or token in a category of purchase known today as a crypto currency (CC). During April 2021, that same one unit reached a price of $60,000 US dollars. The way Bitcoin is created (also beyond the scope of this discussion) does limit supply, which could help to maintain high prices over time. But this tremendous price volatility is an impediment to Bitcoin becoming a usable currency like the dollar, euro, or Japanese Yen. Note some similarities to using gold as a currency, although gold has a long history of being considered of value, exchangeable for then-existing paper currencies.
The claim of limited supply may apply to Bitcoin itself, but there are many other crypto currencies that have come into existence with their own exchange values. Further, government central bankers in charge of creating paper currencies can do so at their pleasure, limited only by the desire to exercise proper monetary controls and avoid harmful inflation. It should also be noted that while Bitcoin does not produce anything, or pay income in the form of dividends and interest, the same is true of most items that serve as currencies. The value of the currency is in what it will buy, its “exchange value”, for a product or service. The search for legitimate items that can serve as currencies continues, but at current exchange values, it is questionable whether Bitcoin or any other crypto currency will do the job.