Brace Yourself, Inflation is Coming

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Investors are obsessed with inflation. And with good reason.

It’s closely tied to interest rates and has ample implications for the relative valuation of current and future profits.

Shifts in the inflation outlook can cause sector rotations and shifts in Wall Street’s weighing of growth versus value, staples versus cyclical, and domestic versus foreign equities.

Inflation expectations are rising. But they could go up further.

With the reopening of the world economy over the coming six months as a catalyst, investors can face a spike in short term inflation.

The below outlines the key reasons for inflationary pressure being imminent.

Further, the implications for investors seeking to optimize their portfolios are emphasized.

The Current Economic Environment in the US

The US economy is rebounding following the swift and large contraction in 2020. Induced by the COVID-19 pandemic and widespread lockdowns, the fall in economic activity in the spring was unforeseen in modern times.

But expansionary monetary policy from central banks across the globe — especially the US Federal Reserve — and continual fiscal stimulus has provided some much-needed cushion.

Compared to the last economic downturn, which followed the financial crisis of 2007–08, the response of policymakers has been quick and substantial.

Monetary policy has been very accommodating.

The Federal Reserve (Fed) has a policy mandate targeting an annual inflation rate of 2 percent. To allow for more flexibility in policymaking, they can choose to over or undershoot this target temporarily but will target an average inflation rate of 2 percent over a medium to long time horizon.

The flexibility is granted due to simultaneous goals for facilitating maximum employment and stable, modest interest rates.

An indicator often looked to is the 10-year breakeven inflation. It recently rose above 2 percent for the first time since 2018 (see exhibit A).