Inflation Is Back: Now Get Ready to Deal With the Consequences

By Sean Williams Markets Fool.com

Have you found that you're needing to part with a bit more of your hard-earned money to buy your usual assortment of goods and services? If so, you're not alone. Inflation is back!

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The Consumer Price Index (CPI), which measures the increase in prices for a predetermined basket of goods and services, rose by a much higher-than-expected 0.6% in January. On an annual basis, the CPI is showing an increase of 2.5%, which is a five-year high. In 2011, inflation briefly neared 4%, and it topped out above 5% during the Great Recession. Of course, we've also had periods of deflation (falling prices) in 2009-2010, and very briefly in 2015.

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Inflation has returned to the eurozone, too. The headline CPI for the eurozone in February showed an annual increase of 2%. The eurozone has particularly struggled in recent years, so to see inflation creeping back in with such force has taken some pundits by surprise.

Inflation is back!

Generally, modest inflation is a good thing. The Federal Reserve has been targeting an annual inflation level of 2%, which would represent modest U.S. GDP growth and allow businesses to pass along reasonably higher prices to consumers. Too far to either extreme is where we start seeing a problem.

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Deflation has the effect of weighing down interest rates, which leads to a critical problem for our nation's retirees who are invested in CDs and bonds. It can also potentially put off consumer purchases. If prices are falling, consumers might choose to wait even longer in order to get a lower price. Since consumption represents about 70% of U.S. GDP, deflation can potentially be more dangerous than high levels of inflation.

On the other hand, runaway inflation is no laughing matter. Whereas higher inflation can coerce consumer to pull the trigger on purchases so as not to pay a higher price later, it also means they won't be able to purchase as much (assuming wage growth doesn't keep pace with inflation). Also, it can push interest rates higher as the Federal Reserve looks to cool down the economy and inflation. That's terrible news for people with credit-card debt, variable mortgages, and even the federal government, which has nearly $20 trillion in debt.

This is why the Fed is so carefully weighing its future monetary policy actions so as to keep inflation as close to the ideal 2% level as possible.

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Inflation has some major consequences for consumers and investors

While most retirees are clearly welcoming inflation back with open arms since it'll probably mean higher interest rates and, therefore, juicier yields on their interest-bearing assets, there are two major consequences consumers and investors should be well aware of.

The obvious consequence is that higher inflation leads the Fed to be more hawkish with its monetary policy. In plainer English, it means the Fed will be looking to keep the economy from overheating by moving its federal funds target rate higher, almost certainly leading to higher interest rates in the months and years that lie ahead.

For the consumer, it means higher variable credit card interest rates, while prospective homebuyers could be facing sharply higher mortgage rates. Mind you, mortgage rates are still historically very low, but past instances of even 75-basis-point increases in the 30-year mortgage rate over a short period of time have sent mortgage applications crashing. There's clearly some concern that eight years of near-record-low interest rates may have spoiled the consumer, just as a traditional sale at a department store has lost its luster without an additional percentage off or coupon.

Perhaps an even bigger, multitrillion-dollar concern is that higher inflation levels could wreak havoc on the stock market. Should inflation move well above and beyond the targeted 2% annual inflation rate (think 4% or higher), we could see a rapid shift in how people evaluate companies and invest. Allow me to explain.

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When inflation is relatively low or modest, investors tend to view corporate growth as meaningful. Companies that can rapidly grow their business in an environment where pricing power isn't all that strong can usually command a pretty high price-to-earnings (P/E) multiple. In short, low inflation typically means a higher P/E is more acceptable to investors.

On the other hand, higher levels of inflation can artificially inflate growth, pushing investors to be more skeptical of growth and favor companies with a lower P/E ratio. Historically, investors have shown a propensity to take inflation levels into account when valuing stocks. Low levels of inflation often mean a greater willingness to accept high P/E ratios, while higher levels of inflation result in lower stock P/Es.

This is worrisome because, according to data from FactSet Research, the current forward P/E on the S&P 500(SNPINDEX: ^GSPC) of 17.9 is higher than the five-year, 10-year, and 20-year averages, and it also marks a more than 12-year high for the index. Years of low inflation have allowed the valuations of S&P 500 companies to expand, but quickly rising inflation levels could reign in those P/E ratios quickly. If earnings are unable to keep up, this could lead to a notable sell-off in stocks.

What's next for inflation is pretty much anyone's guess at this point, but investors should be laser-focused on the Bureau of Labor Statistics' monthly inflation updates since they could have a unique bearing on where the stock market heads next.

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Sean Williams has no position in any stocks mentioned. The Motley Fool owns shares of and recommends FactSet Research Systems. The Motley Fool has a disclosure policy.