Photo: Eric Ward. Source: Wikimedia
The short answer is, nothing. The latest inflation numbers show that the Consumer Price Index grew 2.1% last year, the same as the year before. Core prices grew slightly less. Inflation has averaged around 2% for the last 20 years. In fact, the last time we had a significant increase in inflation was the late 1980s, when core inflation moved up from 4% to 6%. That prompted the Fed to raise rates from 6% to almost 10%, spooking the equity markets and contributing to the recession of the early ‘90s.
This is why long-time market participants obsess about inflation. The Fed has a mandate to keep prices stable. Higher inflation would force them to raise rates aggressively, and this could lead to a bear market and even a recession. There were many factors that led to the stock market crash of 1987, and higher interest rates were one of the most important. Today, inflation remains the most significant risks to the equity market’s bull run.
CPI year-over-year change. Source: Bloomberg
Currently, there are three secular forces holding prices in check: demographics – the world’s population is aging, and old people don’t consume as much as young people; technology – it’s easier than ever to comparison shop, and robotics make it cheaper and cheaper to produce and deliver goods and services; and trade – as global trade increases, the Law of Comparative Advantage dictates that prices should decline. The math is complex, but many natural experiments have supported this economic theory.
This is why today’s very low unemployment rate hasn’t led to an increase in inflation. As long as trade, technology, and demographics continue on their present course, price increases should be restrained. Indeed, technology and competitive pressures led to a marked drop in core inflation this past summer, although those downward pressures on prices seem to have passed, at least for now.
A world economy with low inflation, stronger economic growth, and growing corporate profits and is at the heart of the current global equity market’s bull run. Let’s hope inflation remains grounded.
Douglas R. Tengdin, CFA