What Is “Reflation”?
In recent years, inflation in the United States has remained below the Federal Reserve Bank’s target rate of 2 percent, despite the agency’s efforts to jumpstart economic growth with low interest rates. However, the election of Donald Trump infused the markets with the spark they needed. After an initial drop attributed to uncertainty, the stock market responded with outperformance in the weeks following the election results. Part of this response was in anticipation of the Trump administration’s promises for changes in fiscal policy, such as tax cuts and larger investment in the country’s infrastructure — which could involve issuing new debt.
The first phase in a period of economic growth is called “reflation,” which many economists believe we have now entered. Some of the tools the government deploys to activate reflation include lowering taxes and changing the money supply, both of which appear to be on the horizon.
Signs of reflation include higher prices for consumer goods and higher wages to pay for them. With the low unemployment rate, businesses likely will need to increase compensation to compete for qualified candidates. At the same time, the Fed has already raised interest rates and indicated it will continue to do so, which will increase borrowing costs. In turn, those increases could be passed on in the form of higher prices.
Further, higher wages promote consumer spending, which in turn means higher prices, leading to higher corporate profits. This is a crucial circle for the reflationary phase, which eventually leads to inflation. How much inflation the economy can sustain generally is dependent on whether companies can continue to support higher wages via price increases or a slight reduction in profit margins.
Reflation also can impact investors: Rising interest rates cause existing bond prices to drop. New bond issues will feature the new, higher-interest yields, thereby de-valuing older bonds. In this environment, some investors choose to sell their bonds in favor of either higher-yielding bonds or dividend-paying cyclical stocks. These are called “reflation trades”, because they are made with the expectation that inflation will rise.
Remember, it’s important for individuals to focus on their specific financial goals rather than react to the changing economic environment. If you are considering making changes, please consult with your financial advisor to help assess how any changes might impact your long-term goals.
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