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Stock Investors Beware -- Inflation Incoming, but Rates Will Stay Low

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Tariffs and inflation certainly have a relationship. How are they doing? 

It's complicated.

But don't freak out about your stock portfolio. 

Tariffs and Inflation

With heavy tariffs in place for over a year now and some semblance of more on the way, pundits, economists and strategists are all saying the Federal Reserve should soon cut interest rates, a move that would support stocks. And yes, that's ultimately a very valid conclusion, but a few things will happen in the near term. 

First off, tariffs, on a very technical level, are inflationary. Goods imported to the U.S. from China or Mexico are taxed (the buyer pays the price to the foreign seller plus a tax). That raises the cost to the buyer, essentially raising the price.

"If the trade war continues and all the new tariffs under discussion are implemented, the likely immediate effect would be higher inflation," Anwiti Bahuguna, head of multiasset strategy at Columbia Threadneedle Investments, wrote in a note. 

Nine categories in the U.S. subject to tariffs have collectively seen their consumer price index reading move up to 104 currently from 100 in January 2018, just before the first batch of tariffs on China, according to Columbia's chart.

Plus, "Contrary to expectations that Chinese exporters might lower prices to stay competitive, detailed analysis of import prices (before tariffs) reveals no decline in prices of imported goods that faced tariffs," Columbia said.

Now, American producers are raising prices because the market price of those goods is artificially higher. But the CPI for all other goods has actually stayed relatively flat over the same period. Of course, broad inflation in the U.S. has stayed around a weak 2% for a while. 

So if tariffs are initially inflationary, why would the Fed lower rates? And why would holding stocks be a good idea when the S&P 500 is up 20% year-to-date?

The answer is the long term. 

Tariffs and the Long-Term 

These price increases aren't so organic. They're not happening because U.S. consumers are seeing extraordinary wage growth. Federal Reserve Chairman Jerome Powell last week mentioned to Congress that current wage growth of 3.1% isn't enough to support higher prices. 

Basically, higher prices will ultimately dent demand. "Economic theory tells us that higher prices reduce real purchasing power while lowering demand for goods and services," Bahuguna said.

What ensues? Companies invest less, hire fewer workers to match their muted investment levels, and less consumer spending follows. Demand would fall and so would inflation. 

Case in Point

There's a reason people think the trade war will prompt the Fed to cut rates. Lower rates support stock prices. 

The risk? The U.S. market is hot and upside seems limited, many on Wall Street have said recently. 

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