One Eye on Interest Rates, the Other on Inflation

Not many of us would envy the Federal Reserve’s job of overseeing the U.S. economy. It’s a
monumental task, one that requires vigilant watch and careful utilization of tools that can have
an impact on all Americans. One such tool is using short-term interest rates to spur the rate of
inflation to the desired target.

Generally, interest rates and inflation move in opposite directions. If the Fed wants to
counteract the threat of rising inflation from a strong economy, it can raise rates in a measured
fashion, as it did last year and is expected to do again in 2018. The desired effect would be a
tame and manageable level of inflation for the foreseeable future. But this can be a tricky
balancing act for the Fed, considering there is about a two-year time lag between changes in
interest rates and when we see the ensuing rise or fall in the inflation rate. This is why the Fed
can run the risk of acting too aggressively and overshooting an inflation target.

Below is a chart of the historical inflation rate in the U.S. going back to the late 1950s:

Source: Bureau of Labor Statistics – CPI less food and energy in U.S city average

The current inflation rate, around 2%, is low by historical standards. Some of you might
remember the roaring inflation of the 1970s and early 1980s. We’re nowhere near those levels.
But now that the economy is on its own footing and showing growth, the topic of inflation has
surfaced in the financial media. One could argue that signs of higher inflation have crept into
certain segments of the economy, like housing and employment costs. Even though we’re far from
the high inflation levels of the past, we felt that it was worth a discussion with regard to
how higher inflation might impact your investments.

Inflation & Equities

You might have heard the saying “the market hates uncertainty.” This notion works with
inflation as well, since the impact of higher inflation on stocks can depend on whether it is
expected or unexpected. Companies can plan for expected inflation levels, but it can be a
different story with sudden, unexpected inflation shocks. Corporations would need time to
adjust to rising input costs, and stock prices, in turn, would need to reset to new inflation
expectations. There tends to be an initial negative reaction from the stock market at the
prospect of higher inflation, but aftermarket expectations reset, the focus can return to the
economy and profits.
Stocks are generally considered to be a hedge during periods of rising inflation, and there are
certain areas of the equity market that tend to hold up better. For example, value stocks, like
those in the energy and materials sectors, tend to perform better than growth stocks during
periods of high inflation. Exposure to other asset classes, such as gold and commodities, can
mitigate the impact of inflation on equity portfolios. Therefore, there are ways to shuffle the
equity deck and manage risk when inflation rises.

Inflation & Bonds

Higher inflation has the same effect on bond prices as higher interest rates in that both push
bond prices lower. While bonds are negatively affected by higher inflation, there are steps that
can be taken to offset the impact to fixed income portfolios. These include investing in shorter maturity
bonds, Treasury-Inflation Protected Securities (TIPS), and bank loan funds.
FSA has already begun making adjustments in our income-oriented strategies to manage the
risk of a rising-rate environment. These adjustments to the type of bond funds we’ve been
using will also help cushion the portfolios from rising inflation. Just as the Fed has one eye on
interest rates and the other on inflation, we remain vigilant to watch for signs that it’s time to
make further adjustments.

Mary Ann Drucker
Assistant Portfolio Manager