When you hear the word ” inflation,” you might assume it’s a bad thing. After all, money that’s worth less tomorrow than it is today sounds like a bum deal.
But the Federal Reserve likes a little inflation in the economy — 2 percent, to be exact. Why is this? “It’s not too hot; it’s not too cold,” says Mike Bailey, director of research at FBB Capital Partners in Bethesda, Maryland. “It’s the closest they can get to a perfect number for keeping inflation stable.”
High inflation makes it hard for people to plan their long-term finances. That 2 percent target, on the other hand, is the Fed’s sweet spot between an overheated economy with runaway inflation and a recession — or worse, a depression. Both are associated with deflation, when prices and perhaps wages are falling.
[See: 9 Investing Steps From Warren Buffett’s Playbook.]
The role that purchasing power plays. When workers aren’t seeing wages increase, they’re less likely to make purchases, and that starts to trickle down to a big chunk of the economy, Bailey says.
Inflation that is too low can also hurt companies’ pricing power, holding back increases in earnings, says Don Riley, chief investment officer with Wiley Group in West Conshohocken, Pennsylvania.
The Fed is trying to steer the U.S. economy well clear of what has happened in Japan, which has had low inflation or outright deflation for years, hurting economic growth, says Mark Heppenstall, chief investment officer with Penn Mutual Asset Management in Horsham, Pennsylvania. “Once deflation took hold there, it’s been challenging to say the least,” Heppenstall says. “There’s a lot of fear that if we were to cross over into deflation, that would be a tougher battle to fight.”
It’s hard for businesses to be confident enough to invest for the future if the likelihood is that the money they invest today isn’t going to generate profits, Heppenstall says. When prices go down, it’s harder for corporations to be profitable, he says.
Of course, the flip side of the coin is the double-digit inflation the U.S. experienced in the ’70s and early ’80s. Too much inflation erodes people’s purchasing power and can be driven by a tight labor market and high commodity prices.
[See: 7 Basic Materials Investments to Buy in 2017.]
Interest rates are one of the Fed’s tools for combating higher inflation. Raising rates helps the Fed rein in economic growth in a controlled manner. The Fed’s 2 percent inflation target is low enough that it won’t deter consumers from buying things if prices rise slowly, and high enough to stave off deflationary pressures, Heppenstall says.
The Fed’s conundrum. In the year through July, inflation was 1.4 percent, as measured by core personal consumption expenditures, the Fed’s preferred gauge of inflation, which strips out volatile food and energy prices.
That’s well below the Fed’s 2 percent target, making it unlikely the central bank will raise its key short-term interest rate at its meeting next week, especially as it seems poised for another form of tighter monetary policy by shrinking its balance sheet. “The Fed is a bit confused by the lack of inflation pressures building in the economy given that we’re at what they would consider full employment,” Heppenstall says.
Wages haven’t been rising as fast as expected despite low unemployment, Bailey says. Because wages are a key driver of inflation, if they started to ramp up more quickly, the Fed would likely raise rates at a faster pace, Bailey says. Of course, “the Fed also has the fear of going too fast and hurting the economy,” Riley says.
Fear of bubbles. Keeping monetary policy too loose for too long raises the specter of asset bubbles, encouraging parts of the economy to become overvalued. While the Fed doesn’t want a repeat of the housing market crash, at the moment it seems to be more interested in its goals of price stability and full employment, Riley says.
Bailey thinks stocks may be overheating modestly as the Fed waits for inflation to rise so it can raise its key short-term interest rate. But he’s not in the bear camp that believes a rate hike will cause stocks to plummet. The stock market is not in a “classic bubble,” like those that formed in the housing and dot-com markets, but equities are drawing support from low rates that drive yield-seeking investors into dividend stocks, especially utilities, consumer staples and telecoms, Bailey says.
[See: 10 Dividend Stocks Boasting 100 Years of Payouts.]
Riley thinks that as long as rates stay low, current stock market valuations can be justified. “I don’t think the stock market’s in a bubble, but you’re getting valuations that are pretty rich,” Riley says. “Before the end of a bull market, you have that euphoria stage. We haven’t even approached that.”
More from U.S. News
7 Investment Fees You Might Not Realize You’re Paying
7 ETFs That Let You Invest With the ‘Smart Money’
Why the Fed Wants 2 Percent Inflation originally appeared on usnews.com
