Prepare for Higher Inflation

Katrina Morris

Do you think everything is getting more expensive? It’s not your imagination – prices have generally been rising, and you’re likely to pay somewhat higher prices in the future, too. Overall inflation measures have been rising by about 2%, including the Consumer Price Index (CPI), which aggregates a broad basket of prices based on consumer spending. The good news is the expected inflation rate is also about 2%. That aligns with the Federal Reserve’s target rate and suggests inflation won’t accelerate. But what does the return of moderate inflation mean for you, and how do you prepare your portfolio?
Why is inflation higher?
The biggest expense for most consumers is housing, and rising housing prices have been a major contributor to higher consumer price inflation. In addition, other prices have been edging up as companies try to pass on their higher costs, including rising wages, higher commodity prices and, in some cases, the impact of temporary shortages.
However, many markets remain fiercely competitive, restraining price increases. In addition, other long-term trends that have limited price increases remain strong, including newer competitors, lower-priced sources and products, and continued high capacity in many sectors. We think they’ll keep inflation pressures in check.
Measuring inflation
The chart shows the headline (or overall) CPI and the core CPI, which excludes food and energy prices that tend to fluctuate more. Headline CPI was slightly above 2% in early 2018. Over time, the overall inflation rate tends to move back toward the less volatile core CPI, which has remained around 2%. Although there are many specific ways to measure inflation, most methods show broad-based price increases have stayed under 2%. Keep in mind that your spending is unique and may not match a typical American’s, but the CPI is a good starting place to understand and manage the impact of modestly rising prices on your life.

How does higher inflation affect interest rates and stocks?
Higher inflation generally results in higher interest rates. But as long as inflation remains near 2%, we expect long-term interest rates to rise modestly. And we think the Fed should be able to stick to its current deliberate plan for quarterly short-term rate hikes in 2018. Long-term interest rates started rising last year as inflation started to rise and may continue to move slightly higher as investors anticipate slightly faster wage growth, an increasingly tight job market and more borrowing to fund the federal deficit.
Fears of accelerating inflation – Although we don’t expect inflation to jump, faster economic growth has raised fears of sharply higher inflation and the possibility of an overheating economy. Those could prompt the Fed to react by raising rates at a faster pace to try to stamp out inflationary pressures. And long-term interest rates could also rise in response, slowing economic growth to a crawl. However, we don’t think this scenario is likely.
Possible trigger for market volatility – Fears of higher inflation and rising interest rates are two of several reasons to expect higher stock market volatility ahead. And they’re what prompted stocks to drop briefly by 10% in early February. But remember that while better economic growth may create inflation worries, it also supports rising stock prices over time. When the focus shifts from one to the other, the result can be rapid short-term price moves.
Is your portfolio ready?
Slightly higher inflation is likely to lead to slightly higher interest rates but could also raise fears of accelerating inflation and more market volatility. The fundamentals of better economic growth and solid corporate earnings can help stocks rise over time. Work with your financial advisor to prepare your portfolio with the right mix of stocks and bonds based on your comfort with short-term volatility and your long-term financial goals. And check that your portfolio is broadly diversified with appropriate allocations to all our recommended asset classes.
Inflation is one of the biggest risks for long-term investors, because it eats away at the purchasing power of your money. To avoid being squeezed by inflation, your income needs to rise by at least the same rate as inflation over time. A diversified portfolio of domestic and international equity investments has had higher returns over time than bonds and inflation. Together with your financial advisor, make sure you have enough in those investments to keep the value of your portfolio rising faster than inflation.
 
This article was written by Edward Jones for use by your local Edward Jones Financial Advisor Katrina Morris, AAMS®, 601 E. Main, Suite 125, Alice, TX 78332　361-664-5227.