This article originally appeared in Barron’s on November 3, 2021.
Inflation is currently running about twice as hot as the Federal Reserve would like to see. The question is whether this bout of inflation is merely temporary or the early stages of a longer-term trend. In its statement today, the Federal Open Market Committee noted "sizable price increases in some sectors" and announced plans to begin tapering asset purchases this month.
There are some obvious and well-chronicled ways inflation hurts stock investors. When inflation surges, the Fed typically tightens financial conditions to slow down the economy. That puts pressure on earnings, and also increases the "equity risk premium," or the extra return an investor demands to bear the risk of holding stocks rather than a riskless asset. To be sure, not all companies are affected in the same way; those with pricing power and less reliance on commodities will fare better than their less fortunate counterparts.
But there's another, more insidious way chronic inflation affects stock investors: It causes havoc for anyone trying to place values on individual companies. That's because accounting standards require most companies during periods of inflation to effectively overstate their true economic earnings, while forcing a smaller subset of others to understate them. Corporate earnings in essence become a fun-house mirror.
Read the full article in Barron’s.