Kevin E. Donovan, CFA
Kevin E. Donovan, CFAPortfolio Research Director

Those who remember the late 1970s and early 1980s may find this hard to believe, but inflation is a good thing.  Not the double-digit kind the U.S. suffered through 35 years ago, but a moderate, low to mid-single digit inflation rate is a sign of a healthy, growing economy.  We may be seeing some of that soon.

To understand why moderate inflation is good, let’s look at the opposite, which is deflation.  Imagine a world in which prices steadily go down over time.  Consumers would put off buying goods for as long as possible because next year, or next month, those goods would be cheaper.  Especially on big ticket cars or appliances, if it isn’t broken, you can get a better deal just by holding on to your current washing machine, refrigerator or SUV for a little while longer.  That may be good for you, but it is terrible for businesses selling those products and is a serious negative over time for an economy such as ours that is dependent on consumer spending.

That scenario has been what has been happening in Japan for more than 20 years.  Deflation is incredibly difficult to break out of once it takes hold.  Manufacturers lower their prices to get consumers to buy their goods, but the consumers are conditioned to expect lower prices if they wait.  Desperate manufacturers lower their prices even more and the economy enters a deflationary spiral that, in Japan’s case, has gone on for decades and has been one of the major reasons their economy has been so poor over that period.

With moderate inflation, consumers expect prices to be slightly higher in the future so they have more incentive to make those large purchases sooner and more often.  This increased consumer spending stimulates the economy and causes it to grow, creating more jobs, pushing up corporate earnings and, hopefully, fueling gains in the stock market.

Since the 2008 recession and the Federal Reserve’s dramatic reduction in interest rates, the U.S. economy has grown slowly and inflation has remained very low on an historic basis.  The latest data from April showed that the overall Consumer Price Index (CPI) in the U.S. rose at a 1.1% annual basis as gas rose slightly and food prices increased.  That was slightly offset by a decline in clothing and car prices compared with last year.  That rate is well below the 50-year average CPI rate of 4.1%.

The big driver of inflation that has been missing since 2008 has been wage growth.  While unemployment has come down dramatically from its peak of 10% in October 2009 to 5% in March 2016, wages have not risen.  Wages may rise soon, however.  At this low level of unemployment it will become more difficult for companies to find the qualified workers they need so they will have to increase wages in order to attract new hires and to keep the ones they have.  This additional money in workers’ pockets should cause spending to rise, pushing up demand for goods and services and, thus, inflation should move up toward more typical levels.

The return of moderate inflation would provide the Federal Reserve with some of the rationale it has been looking for to resume its interest rate increases.  Although the market usually reacts negatively to interest rate rises in the short-term, higher rates are a sign of a healthy economy and markets tend to advance over the longer-term.  Higher rates also mean more income from bonds for investors who rely on their portfolios to fund their retirement.

The economy is very complex, with many moving parts and inputs that can lead to growth or recession.  Moderate inflation is only one of the factors that can help stimulate the economy higher, but it is one of the important factors and the return of some inflation can be a good thing.