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Does More Stimulus Mean Higher Inflation?

The fiscal and monetary policy relief measures we have seen over the past year have truly been historic. In order to stave off the worst effects of the economic shutdowns, Congress has been forced to pass trillions of dollars of stimulus (with more likely on the way) and the Federal Reserve was quick to reduce interest rates and enact quantitative easing at an unprecedented scale.

With many economic indicators reflecting a quicker-than-expected rebound, it can be suggested that these policy measures were largely successful.

Many, however, have grown wary of the possibility of a return to inflation as a result of this stimulus. At what point do the long-term ramifications of money printing outweigh the short-term relief that is being felt across the economy? This question has become hotly debated over recent months.

The chart above depicts the market’s consensus view that recent stimulus measures should result in more inflation, with a 2.21% expected annual inflation rate over the next 10 years.

long-term-inflation-expectations

It’s important to emphasize that this reflects the market’s expectation for inflation over the next 10 years and doesn’t reflect actual inflation rates. In 2011, for example, the expectation for inflation was north of 2.5%, yet according to LPL Research, inflation averaged well below that at 1.8% over the last business cycle.

The market consensus estimate reflects a level that is only slightly higher than the Federal Reserve’s 2% inflation target, however. Furthermore, the Fed adjusted this target to a 2% average inflation rate from its previous target of a 2% ceiling. In adjusting its target, one can infer that the Fed is acknowledging just how difficult it has been to increase real inflation over the past decade and that a modest increase would actually be healthy.

Forces that may contribute to higher inflation include many factors caused by the Covid-19 shutdowns, including the:

  • Ensuing economic comeback
  • Continued stimulus
  • Higher-than-expected savings rates
  • Potential for pent-up consumer demand being expended when reopenings occur

Having said that, several factors can inhibit any rise in inflation. These include the:

  • Many long-term demographic and economic phenomena that were present long before the Covid-19 crisis
  • Recent rise in unemployment stemming from the economic shutdowns

According to LPL Research, how these inflationary tailwinds and headwinds balance out will likely determine the extent of the reflation or inflation we will see in the coming years.

Given the possibility of an uptick in inflation in coming years, some investors have taken steps to hedge their portfolios against this risk. Amongst these hedges are certain asset classes that, according to Bloomberg, have historically performed well in inflationary environments. These include industrial and energy commodities, companies in the materials and industrial sectors that can benefit from an uptick in economic activity and commodity prices, and inflation-protected bonds.

While making tactical adjustments at the margins in response to economic conditions can be prudent, refraining from overconcentration in a portfolio in any one area can be equally important to investment returns. History and academic research have shown that those who remain committed to a diversified portfolio tailored to their specific goals and needs can counterbalance risk in their portfolios and ultimately reduce volatility.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Hapanowicz & Associates, a registered investment advisor and separate entity.

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