Kristina Hooper, CFP®, CIMA®, is US head of investment and client strategies for Allianz Global Investors. She has a B.A. from Wellesley College, a J.D. from Pace Law and an M.B.A. in finance from NYU, where she was a teaching fellow in macroeconomics.
While low rates are staying put for now, the Fed’s easy money does come with a price tag. Last week’s sudden, sharp rise in inflation is a reminder of how quickly purchasing power can evaporate and that there’s a downside to the aggressive central-bank stimulus that has lifted stocks to near-record highs.
The stock market posted another strong week of returns but finished on a down note on Friday, as disappointing data revealed higher inflation and a drop in consumer sentiment. Indeed, the Dow’s historic 10-day winning streak was stopped in its tracks as the preliminary March consumer sentiment reading gave investors pause. According to the University of Michigan/Reuters survey, consumer sentiment negatively surprised at 71.8, which was substantially below Briefing.com’s estimate of 79.0. It also showed a significant decline from the February final reading of 77.6. What was so frightening for investors is that a number in this range, historically, has been more commonly seen during recessions.
But it wasn’t just consumer confidence that took a hit. The Consumer Price Index also helped sound the death knell for the stock rally, at least temporarily. On Friday, it was reported that CPI rose 0.7%, its biggest increase since June 2009. The rise was largely due to a jump in the gasoline index, which was up 9.1%. In addition, electricity, fuel oil and natural gas prices all rose, bringing the overall energy CPI to a 5.4% increase from January. It’s clear that consumers, particularly those in lower-income brackets for whom necessities such as food and energy make up a much higher percentage of their disposable income, are being squeezed. Add the payroll tax to the equation and it seems logical that sentiment has weakened as much as it has.
Easy Does It
Some investors may have also worried that a big increase in inflation would jeopardize the Federal Reserve’s policy of keeping interest rates artificially low. The Fed has said repeatedly that it will maintain low rates until unemployment dips below 6.5%—unless the Fed sees inflation heading above 2.5%. While CPI ex-food and energy (also known as “core CPI”) was up only 0.2% for the month, and 2% year-over-year, the Fed is actually now targeting “headline PCE” or personal consumption expenditure as its primary measure of inflation. This inflation indicator does factor in the more volatile food and energy prices, but the Fed is not looking at it on a month-by-month basis. Rather, it’s making a prediction over where inflation will be two years from now, so it doesn’t seem to be in any danger of triggering a rise in rates now.
However, it stands to reason that, at some point, core CPI will rise significantly, given the enormous amount of monetary and fiscal stimulus that has been rained upon the economy in the past several years. America’s easy-money policy remains intact, at least for now.
While US monetary policy remains in play, Japan’s monetary policy appears poised for a dramatic change. Last week, Japan’s Parliament confirmed Prime Minister Shinzo Abe’s choice to run the Bank of Japan, Haruhiko Kuroda. Kuroda has repeatedly argued that Japan’s central bank needs to be more activist in nature, in that effective monetary policy can solve the country’s economic problems, including deflation. He is expected to propose new monetary policies such as expanding quantitative easing, embarking on qualitative easing, setting a target for expanding the monetary base or a combination of these initiatives. Investors showed their approval by bidding up Japan’s stocks on news of Kuroda’s confirmation—the Nikkei is now at its highest level since prior to the Lehman Brothers failure in 2008. Conversely, the yen is actually down 17% since Nov. 13 when new elections were announced and investors began anticipating that Abe’s government would overhaul central-bank policy.
The concept of an activist central bank and a monetary policy of financial repression seems appealing to Japan and a number of other countries. Some political leaders are actually pointing to the United States as an example of how such policies can stimulate an economy. The added benefit is that, with the yen significantly lower, Japan’s exports look far more attractive. In addition, other countries may be envious of the report last week that the Fed sent a record $88.4 billion in profits to the US Treasury Department last year. This income was largely a result of the Fed's massive bond purchases including $80.5 billion in interest on the Treasury bonds and mortgage-backed securities.
However, countries that embark on financial repression must be aware that it’s not a flawless solution. The consequences can be costly: Low rates mean low yields on Treasuries, CDs and money markets. Not only are savers punished under financial repression, but also such dramatic stimulus typically results in significant inflation over the longer term. Last week’s CPI number may have been frightening because it served as a reminder that inflation can strike—and strike violently—when we least expect it.
Investors need to prep for that potential jump in inflation by having adequate exposure to asset classes that have historically performed well in inflationary periods. Dividend-paying stocks, TIPS, high-yield bonds, convertible bonds, commodities and real estate have all typically performed well in inflationary environments. Investors seeking to protect against inflation should consider these asset classes.
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