Why Inflation Could Strangle the Economy

Without a doubt, there’s one piece of data coming out on Wednesday that will have traders glued to their screens – the latest inflation numbers.

Inflation is something I think and write about a lot. That’s because historically it has played such an important part in the markets.

So, with inflation on the rise, I’m watching it closer than ever…

It’s all about interest rates

Coming into the start of this year, inflation just wasn’t on most investors’ minds. Inflation data was stagnant through most of 2020, with little change expected for this year.

And, with a 1.4% inflation reading in January, it seemed like the status quo would remain.

However, as inflation rose suddenly over progressive months, stories about inflation started to appear all over the news…

We all know that inflation refers to the erosion of value. Or in dollar terms, the decline in purchasing power.

However, when it comes to placing a value on money, you need to consider more than just inflation.

Interest rates have equal importance… the two go hand in hand.

The reason for that simply comes back to the math…

If someone can borrow money at say, 2.5%, and inflation is running at 5%, it’s pretty clear someone is going to lose. And in this example, it’s clearly not the borrower.

They’re paying back their loan with dollars that are continually decreasing in value.

With low interest rates and inflation at 1.4% in January, this was not such a big issue. However, with inflation hitting 5.4% in June, the correlation between the two got all out of whack.

If this disparity continues, the lender has no choice other than to jack up their rates. Why would anyone lend at 2.5% per year when those dollars are devaluing at 5% over the same period?

It just doesn’t stack up. That’s why the upcoming inflation numbers are so important.

Having reached 5.4% in June (with the same number in July), inflation dipped ever so slightly in August to 5.3%.

General market forecasts put September inflation at 5.2%. Until we find out on Wednesday, we’ll just have to wait and see if that comes true.

So far, the market has shrugged off the rise in inflation. While inflation rose almost fourfold in the first half of the year, the S&P 500 rallied 16% over the same period.

However, the way I see it, unless inflation starts to fall, interest rates will have to rise. And that would be bad for the market.

That’s why right now all roads lead back to the Fed…

The Fed’s high wire balancing act

Whichever way you slice it, the Federal Reserve is playing a balancing act. They’re trying to get the balance right between interest rates and inflation.

As they have stated numerous times, their belief is that this spike in inflation is “transitory.” And that once supply bottlenecks open up, prices will come back to normal.

For the Fed, that normal is 2% inflation – and this has long been its target. The challenge is what will happen in the meantime.

If inflation stays too high for too long – without an accompanying move up in interest rates – it could be even harder to rein it in down the track.

And that could mean the Fed might have to raise its rates quickly to get inflation back under control.

That’s why the notes from the Fed’s most recent Federal Open Market Committee (FOMC) – due for release in the early hours of next Thursday morning – will make a compulsory read.

In those notes, the Fed will be sharing its thoughts on inflation and other important data. They’ll need to reassure the markets that the spike in inflation is really decreasing.

I’ll be sure to let you know if anything stands out.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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