For most of this economic expansion, inflation has essentially been a non-factor. In spite of the Federal Reserve lowering interest rates to the zero bound for several years while also engaging in quantitative easing programs designed to pump liquidity into the economy, the inflation rate has rarely touched its 2% target.1 In the early years following the 2008 Financial Crisis, there was simply too much slack in the economy for inflation to take hold, and banks were doing the exact opposite of what it typically takes to spur inflation – they were hoarding cash instead of lending it.

Fast forward to 2018, and we have an economy that is arguably at full capacity with very little slack. The unemployment rate now sits at 4.1%, and companies frequently cite difficulty in finding new skilled workers.2 Wage pressures are on the rise, and the market seems to be increasingly sensitive to how all of these factors together might affect inflation.

In Recent Years, Inflation Has Been Ticking Steadily Higher

 

Source: Bureau of Labor Statistics; Federal Reserve Bank of St. Louis

The Federal Reserve has largely been “sticking to the book” in terms of their response. In theory (and in historical practice), when the economy gets to full capacity with tight labor markets and wage pressures, a logical response from the central bank is to raise interest rates in an effort to push back on inflation. That’s what the Federal Reserve is largely doing according to script today, with a widely-expected rate increase in March and two to three more planned for the year.

The federal government, on the other hand, is arguably taking the exact opposite approach. Generally speaking, an economy at full capacity would argue for reduced government spending and a steady ship as it relates to tax cuts. Instead, what we have today is a sizable tax cut and significant increases in spending. The question at the end of the day is, will the inflation impact of the fiscal stimulus eventually force the Federal Reserve into an unplanned response?

That, in my view, could be the source and cause of the next recession.

Bottom Line for Investors

The overarching concern in the marketplace, in my view, is that rising inflation could influence the Fed to raise rates more quickly than planned, an action that some investors fear could bring the economic expansion – and bull market – to a halt. My take on this issue is that inflation may start to set-in more quickly than expected sometime later in the year, but by then I think the Fed will have already raised rates at a pace that puts them in a good position to avoid having to negatively surprise the market.

For investors, I’d forewarn that higher-than-expected inflation readings are likely, in my view, to trigger volatility in the stock market, so don’t be too surprised if one leads to the other. I wouldn’t get bearish until we’re able to gauge the Fed’s response.

Disclosure

1 Bureau of Labor Statistics
2 Bureau Labor Statistics, April 6, 2018, https://www.bls.gov/news.release/pdf/empsit.pdf

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