Why Investors Shouldn't Be Afraid of Inflation

Barring an unlikely economic meltdown, the Federal Reserve is on track to raise interest rates. I believe that fundamental factors, such as record-low inflation, slow economic growth and aging investors’ rising risk aversion—not the central banks—are the major reasons that interest rates are near zero. The Fed has supported these low rates in an attempt to spur a solid economic recovery.

But now it’s time to “normalize” the level of interest rates. Although the economy has been growing at a rate well below its historical trend, the U.S. labor market has been strong, adding 2.7 million new jobs in 2015 on top of 3 million in 2014. The pace of job growth has slowed a bit this year, but monthly payroll gains—until the disappointing May number—averaged a solid 177,500 in the first four months of 2016. Furthermore, the unemployment rate has fallen to 4.7%, below the level considered by economists to be full employment.

The prospect of raising short-term interest rates by one-fourth of a percentage point from the current range of 0.25% to 0.50% is really a very small increase. The stock market’s initial reaction to the Fed’s comments in the spring that indicated a willingness to raise rates was surprisingly positive. That’s because the Fed’s comments reflected confidence in the U.S. economy and more-positive expectations for future corporate earnings.

The threat of deflation has eased substantially since early this year, and inflation is picking up. The price of oil has roughly doubled since February, and retail gasoline prices are up by more than one-third. In addition, the Case-Shiller housing price index is up 5% from year-ago levels, and rents are rising at least as fast. Even if mortgage rates were to rise in the face of Fed tightening, rates still remain low by historical standards so they won’t derail the housing recovery.

Not only have consumer prices ticked upward, but wages are also beginning to rise. Year-over-year hourly earnings were up 2.6% in January, a seven-year high, and are now rising at 2.5%. Normally, wage increases of this magnitude would pose little risk of inflation. But with productivity growth near zero, any wage increase puts upward pressure on labor costs. In addition, more states and localities, especially in New York and California, have hiked the minimum wage. And the Department of Labor has nearly doubled the salary limit under which firms must pay workers overtime (see New Rule Boosts Overtime Pay).

Outlook for stocks. All these factors mean that both inflation and interest rates will almost certainly rise in the coming months. But the increase won’t be anything like the high inflation experienced by the U.S. and the rest of the world in the late 1960s, 1970s and early 1980s. A moderate inflation rate of 2% to 3% is actually good for stocks because it gives companies the power to raise prices, which helps boost profits and eases the real burden of debt and pension obligations.

Bond investors are in a more difficult position. Even though the rise in long-term rates will be moderate (the 10-year U.S. Treasury bond is unlikely to go above 3% from 1.71% in early June), bond funds will sink in value and interest rates on short-term CDs will stay well below the rate of inflation. For income, dividend-paying stocks are a much better bet for investors.

Bottom line: Stock investors shouldn’t fear the early stages of rate increases by the Fed. If the Fed raises rates, it will reflect not only higher inflation but also a strengthening economy. Corporate profits—and hence stock prices—can do quite well in this environment.