What Happens When Inflation is High? Effects on the Economy

Inflation may not have been top of mind until recently. However, it’s a normal principle of economics. Revisiting the basics of how inflation can affect the economy can make adjusting to it easier.

Inflation Happens

In its simplest form, inflation is the rising prices of goods and services over time. It means today's dollar won't buy as much down the road. In other words, it reduces your future purchasing power. 

What Triggers Higher Rates of Inflation?

Here are just two common ways to describe the types of inflation. But there are many factors that can contribute to inflationary pressures.

• Cost-push inflation happens when the cost of a product increases and supply decreases while demand generally stays the same. For example, the costs of raw materials or labor used to make items increase.

• Demand-pull inflation is the opposite of cost-push. If there’s high consumer demand for a product and supply can’t increase enough to meet it, prices often increase. Think about a high-demand holiday gift; when there’s a shortage, people may pay far more than the market price to buy it now.

Today, investors are facing a historic combination of domestic and global factors that have sent inflation to levels we haven’t seen in 40 years. The sharp and rapid rise in consumer prices stems In part from issues related to the global pandemic.

• Soaring energy and other commodity prices from the resurgence in demand.

• Higher labor costs as companies seek to overcome labor shortages.

• Pent-up consumer demand after pandemic-related shutdowns.

• Global supply chain bottlenecks.

Several longer-term trends suggest inflation may remain more elevated than initially predicted. These more persistent inflation factors include rising housing costs, higher energy and commodity prices, onshoring trends as well as aggressive fiscal and monetary policy.

How Does Inflation Affect the Economy?

Typically associated with an overheated economy, persistently high inflation harms consumers and dampens economic activity. As consumers’ budgets are hit with higher costs on goods and services—from paying more for groceries, gas and heating/cooling homes to giving the babysitter a raise—they tend to decrease spending on non-essential items.

To protect the economy’s long-term health, the Federal Reserve (Fed) is increasing interest rates to cool demand. But the war in Ukraine is complicating the Fed’s and other central banks’ decision-making processes. The conflict and economic sanctions may cause a significant slowdown in global growth.

The ultimate question facing investors is, "Can central bankers tame inflation without choking off economic growth?" For now, our investment professionals believe the Fed will keep to its stated series of measured rate hikes followed by balance sheet management to help rein in U.S. inflation. At the same time, it has its eyes on the potential for stagnating economic growth in the U.S. and Europe.

Stay up-to-date with our latest views in Investment Outlook.

Combating Inflation in Investment Portfolios

There are some investment sectors that have historically performed well in times of high inflation.

• TIPS (Treasury inflation-protected securities) are a class of U.S. Treasury securities created to help protect investors in the long term against inflation. As inflation rises, the principal value of TIPS increases, creating a steadily growing stream of interest payments.

• REITs (real estate investment trusts) may be appealing to some investors. It’s a broad and diverse sector, but exposure to properties that can demand higher prices or increase rents can be beneficial. And REITs must distribute at least 90% of their taxable income as dividends, so when rents rise those dividends increase.

• Commodities historically have risen in value along with inflation as the costs of the raw materials to make goods rises. The energy sector, including oil and gas, has tended to fare better than other sectors of the economy during a period of high inflation.

• Stocks, with their higher growth potential, historically have helped to shield investors from inflation’s fury. And choosing the stocks of companies with the ability to pass on higher prices to customers may make an even greater difference. 

Fears about inflation are normal, but you can put these times in perspective by looking at the bigger picture. Understanding some basic economic concepts can help you make smarter decisions on day-to-day spending and saving as well as long-term investing.