Two weeks ago, stronger-than-expected wage growth triggered a stock market sell-off that resulted in a brief but full-fledged correction.
Investors were concerned that higher wages might lead to higher inflation – and that the Federal Reserve would take preemptive action by raising interest rates more aggressively.
(Higher rates, of course, make it more expensive for individuals, businesses and governments to borrow – and make cash and bonds more attractive relative to stocks.)
We got more bad news on the inflation front Wednesday when Uncle Sam reported a higher-than-expected 2.1% rise in the consumer price index (CPI).
This unwelcome news hardly affected stocks but caused a sell-off in the ever-vigilant bond market.
Few investors believe higher inflation and interest rates are beneficial, especially when they put a dent in financial markets. But at the present moment – believe it or not – they actually are.
For starters, it shows that the patient – the U.S. economy – is finally healthy enough to get off the life support of ultra-low interest rates.
A decade ago, no one in his right mind would have believed that rates would still be near zero today. (Yet look at the crumbs your bank throws your way for the pleasure of lending against your deposits.)
The extraordinary measures taken by the Fed to avoid a protracted downturn – including quantitative easing (QE) rounds 1, 2 and 3 – were meant to be temporary.
But 10 years is an awfully long time for “temporary measures.”
The central bank is now intent on normalizing rates. Savers have been unfairly punished for too long. And the Fed wants to put the arrows back in its quiver.
Think about it…
If we started sliding into a recession, the traditional monetary response would be to slash interest rates. But when the fed funds rate is just 1.5% as it is today, there isn’t much to cut.
Moreover, investors are hardly in the mood for QE 4, 5 and 6. (Especially since the Fed is trying to unload the $4.5 trillion dollar bond portfolio it already owns.)
Waiting for an economic downturn to splurge on public spending is no longer fashionable either.
Republicans lost their minds over Obama’s deficits, just as Democrats went bonkers over his predecessor’s. But now that the Republicans are back in power – and can spend on their own priorities – they’ve decided that adding to the sea of red ink isn’t such a bad idea after all.
The federal debt now stands at a gargantuan $20.6 trillion.
Yet over the next few years we’ll see the return of budget-busting deficits, thanks to more military spending, more infrastructure spending, more social spending and a border wall that Mexico – surprise, surprise – will not pay for.
In short, we’ve had the ultra-loose monetary policy. We’ve had the big-spending fiscal policy. And we’ve had the huge corporate tax cut.
So let’s be grateful the economy is heating up. Because if it were running down right now, we’d find the medicine chest is just about empty.
Strong growth, better wages and a boost in the CPI give the Fed the green light to bring sanity back to interest rates.
I don’t ordinarily view higher prices as a good thing. After all, inflation is the thief that robs us all.
But investors can always hedge against inflation with precious metals, with real estate, with Treasury Inflation-Protected Securities and with the greatest inflation hedge of them all: common stocks.
But how do you hedge against an economic downturn when rates are near zero, public spending is already reckless and debt levels are unsustainable?
You can’t. So let’s be grateful that inflation and interest rates are coming back.