The impact of inflation is clearly negative on the broader economy. It hurts the credibility of the Federal Reserve, whose primary goals include price stability; undermines the dollar's buying power and appeal to foreigners (as a debtor nation, we don't want that); and provides yet another disincentive for Americans to save because cash loses its value over time when inflation is ascendant. Inflation is also a problem because various federal programs (including Social Security, Veterans Benefits, Medicaid) have cost-of-living adjustments built into them. As inflation -- as measured by CPI -- goes higher, the payments increase, putting an increasing burden on the federal deficit. But inflation's effect on corporate profitability and equities is particularly pernicious.
Inflation Raises Corporate Borrowing Costs: As these expenses increase, the extra price paid to borrow comes right off of the bottom line.
Inflation Squeezes Margins: As producer prices go up, companies often have the Hobson's choice of either raising prices -- and risk losing sales -- or eating the higher costs. If they cannot pass thru wholesale price increases, margins get squeezed, hurting earnings.
Competition for Capital: As rates rise, bonds become increasingly more attractive. Better yields, no-risk, tax-free Treasuries pull money away from the stock market; this is one of the biggest dangers to equity investors. Watch the flow of funds away from equity mutual funds. Ultimately, this can lead to lower prices.
Recessions: Inflation causes the Fed to tighten, and often at the same time, rising energy prices crimp consumers. A recent study by Merrill Lynch's David Rosenberg noted that when the Fed tightens and oil prices rise, GDP typically contracts. When all three factors coincide, that does not bode well for the macro economy and equities.
It is crucial for investors to have a realistic understanding of how robust inflation is. Doing so early reveals investment opportunities that those who focus on the core CPI have missed. In particular, oil, commodities and gold have been attractive investments overlooked by the "no inflation" crowd. Now, as the Fed rate tightening cycle goes from being accommodative to neutral and beyond, the risk to domestic equity holders increases. I have been advising clients that as we come to the end of 2005, they should be getting increasingly defensive. In addition to owning gold, they should be looking to increase their exposure overseas. Those who live in a synthetic reality -- seasonally adjusted, hedonically altered -- will confront the unpleasant reality of the real universe. Ignoring inflationary data in the CPI won't make it go away. All that accomplishes is to shift the focus away from precisely where it should be: on the part of CPI that has been rapidly increasing in price. Those who fail to grasp this will pay a heavy price for their self-imposed ignorance.