While things are looking up this year, there is going to be major upward pressure on interest rates going into 2012. The reason is price inflation, and it’s coming with some significant fervor.
This isn’t any big prediction. All you have to do is follow the commodities market to know that the cost of raw materials is going up. As these higher prices move through the supply chain, eventually the consumer will be faced with more difficult choices.
Some price inflation is good. This is what the Federal Reserve has been trying to create by dramatically increasing the money supply after the financial crisis. Going forward, central bankers are going to have to walk a tightrope, because they don’t want kill off the very growth they’ve been so anxious to create.
Most central banks in developed economies tend to have a general target for the rate of inflation, and it’s around two percent. In Britain, the latest consumer price inflation number for January came in at four percent, or double the Bank of England’s target. Retail price inflation, which includes housing, grew to 5.1% in January. This is the highest rate of inflation in that country in over two years and January is typically a slow month due to retail discounting after Christmas. This is not a good development and it dramatically increases the probability of a sustained new up cycle in British interest rates.
Like I say, some price inflation is good. GM’s decision to pay some of its workers a sizeable bonus will obviously help labor incomes, which will help consumer spending. Many companies are announcing price increases for their products and services without affecting demand and this is going to help corporate earnings. The key to it all is reasonable price inflation and reasonable interest rates that don’t kill the economy. Monetary policy is going to change very soon to deal with the return of inflation.
For equity investors, some price inflation is also helpful. But it’s also the very thing that can rattle investor confidence in reaction to new interest-rate policies from the Fed. Inflation and interest rates could be the catalyst this year for a major stock market correction.
I’ve been writing for quite a while now that equity investors should be long the market. I’ve also been saying that there’s no need to be jumping on any bandwagons with new positions. The market action has been good over the last six months, but I hate to say it—the monetary fundamentals are deteriorating.
Right now, there isn’t a great need to make any major adjustments to a balanced equity portfolio that’s long. But, I can’t escape the feeling that the tide is very soon about to change.