Will the Inflation “Cure” Kill the Markets?

By most indications, the economy is white hot, growing with such force that its handlers are having trouble keeping it under control. And not just the U.S. economy. Central banks around the world are raising interest rates in an attempt to rein in the inflationary effects of rapid economic growth.

So why has the stock market been so volatile?

The major U.S. stock indexes have all been on a roller-coaster ride since the beginning of the year. The Dow Jones Industrial Average — a widely tracked measure of large, established companies — fluctuated back and forth across the closely watched 11,000 mark more than a dozen times during the first half of the year.¹ Other U.S. indexes — and stock markets from Turkey to Japan — have also seen wide fluctuations this year. The juxtaposition of solid economic growth and flagging market performance is a puzzling circumstance. Examining some of the reasons behind this unusual situation may help you better understand how to react.

So Long, Easy Money

Many economists believe that the markets are struggling to adjust to rising interest rates, which are draining liquidity from a world economy that has grown used to the “easy money” of the past few years.

Inflation can be an unfortunate side effect of economic growth. If growth gets too hot, prices may spiral rapidly upward. Ironically, if inflation is allowed to flourish, it can squelch the very growth that caused it. In the United States and abroad, policymakers use interest-rate adjustments to help strike a balance between inflation and economic growth.

When growth is strong and inflation pressures are present or threatening to appear, policymakers — the Federal Reserve fills this role in the United States — will raise certain key interest-rate targets, making money more expensive to borrow, thus helping to reduce liquidity, or the supply of money.

When inflation is low but the economy is struggling to grow, policymakers may lower interest-rate targets to make more money available, with the intention of enticing consumers and businesses to spend and invest more.

And so, in response to a short recession in 2001, followed by the fearful times of the September 11 aftermath, the Federal Reserve pushed interest rates down to record low levels. This was apparently what was needed to help spur the U.S. economy because it responded with a steady torrent of growth that continues today. And as the United States goes, so goes the rest of the world. Interest rates came down around the world, and the global economy too began to grow.

Which brings us to today. Americans and the rest of the world have grown accustomed to a relatively low cost of money. But the party has to end, according to the central banks, which are perhaps more concerned about the effects of inflation on the economy than the effects of higher interest rates on the financial markets.

Interestingly, markets around the world appear to be concerned that rising interest rates will exceed their intended effect — that policymakers will raise rates too high and squash growth. History girds their fears. The 1987 stock market crash, the bursting of the Japanese real estate bubble in the early 1990s, the Asian financial crisis of 1997, and the rapid descent of the Nasdaq in 2000 all coincided with rate-raising campaigns by the world’s central banks.²

Rising interest rates can have all sorts of negative side effects that financial markets don’t like.

Even though the long-term economic outlook is fairly bright, there’s no guarantee that the current tightening by the central banks won’t cause some short-term pain. This is an unusual time that will require investors to react with skill and patience.

1) Thomson Financial, 2006, for the period 1/3/2006 to 6/21/2006. The performance of an unmanaged index is not indicative of the performance of any particular investment. Individuals cannot invest directly in an index. Past performance does not guarantee future results.
2) The Wall Street Journal, June 14, 2006

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