Investing Archives | Page 61 of 221

Sep

2023

What Is Quantitative Easing?

By Laurel Tincher | Growing Wealth, Investing, Terminology | No Comments

Quantitative easing (QE) is a monetary policy tool in which a central bank attempts to stimulate growth in the economy by buying bonds or other financial assets in the open market.

When the central bank purchases assets, the money they’ve spent gets released into the market, increasing the money supply in an economy. QE is an unconventional monetary policy tool that’s usually used by a central bank when traditional tools — like lowering interest rates — are no longer effective or an option.

How Does Quantitative Easing Work?

Quantitative easing makes it easier for businesses to borrow money from banks, by essentially lowering the cost of borrowing money.

The Federal Reserve, or Fed, is the central bank of the United States. The Fed notably conducted multiple rounds of QE after the 2008 financial crisis. The U.S. central bank also embarked on a QE program in 2020 when quarantine measures were put in place due to the Covid-19 pandemic.

When the Federal Reserve purchases securities from other banks, it issues a credit to the bank’s reserves, thereby figuratively increasing the money supply. No funds actually change hands in a QE program. The funds used to purchase the securities are essentially created out of thin air as a credit. Hence, QE is often referred to as “printing money” since the central bank is boosting the fiat currency supply.

When the Fed purchases Treasuries from the government, this also keeps Treasury yields low by increasing the demand for them. When Treasury yields stay low, long-term interest rates remain low, which can make it easier for consumers to take out loans for a car, house, or other types of debt.

Banks are required to have a certain amount of money on hand each night when they close their books. This is called the bank reserve requirement. QE gives banks more than they need to hit this reserve requirement. When banks have extra money, they lend it out to other banks to make a profit. This can also help stimulate the economy.

In addition to making it easier for banks to give out loans, QE keeps the value of the U.S. dollar lower, which in turn lowers the cost of exports and makes stocks attractive to foreign investors. All of these factors can help to keep the economy running during challenging times.

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When Low Interest Rates Aren’t Enough

While Congress controls government spending and tax rates — what’s known as fiscal policy — the Federal Reserve controls short-term interest rates, which are the main tool used to prevent or lower the impacts of a recession — a system known as monetary policy.

More specifically, the Fed adjusts the rate that banks have to pay to one another to loan money that is held in Fed accounts. If banks can borrow money at a lower rate, they in turn can lend money to their customers at a lower rate.

Central banks have long preferred to lower short-term interest rates to expand the economy and encourage more spending. Similarly, the Federal Reserve raises interest rates to slow inflation. But when interest rate cuts aren’t enough to stimulate the economy, as is now the case, quantitative easing is sometimes used as a last resort.

One limitation on interest rates is that they can’t practically be lowered to less than zero. Technically, negative interest rates are possible, but this would mean that banks would actually be paying people to borrow money, rather than the other way around.

When interest rates fall to near zero, and banks, corporations, and individuals hoard money, this results in a lack of liquidity in the market. Quantitative easing can help release money back into the market. The asset purchases will take place over the course of several months. The goal is to make sure that businesses have sufficient funds to lend to other businesses throughout the economic downturn.

Does Quantitative Easing Cause Inflation?

One of the biggest fears about quantitative easing is that it will cause too much inflation, or price increases. In such a scenario, inflation would occur because there’s a lot of money in the system.

Some economists argue that if the money supply increases quickly, it increases demand as more people have ample money to spend. That, in turn, can raise prices rapidly or encourage reckless financial decisions.

Some degree of inflation is healthy and normal. For instance, in the U.S., the Federal Reserve targets an inflation rate of 2%. But inflation rates that are too high can be painful for consumers. For instance, during the 1970s, the inflation rate averaged 7% and hit double-digit levels in 1974 and 1979, causing the prices of some goods — most notably oil — to skyrocket.

Past Examples of Quantitative Easing

A relatively new strategy, quantitative easing has been used a number of times over the past 20 years, with varying degrees of success.

Quantitative Easing in Japan

The first example of an advanced first-world country implementing a quantitative easing program was Japan in 2000-2006. Japan entered into a recession following the Asian Financial Crisis of 1997.

The Bank of Japan bought private debt and stocks through the QE program, but the program didn’t result in the stimulus they had hoped for. Japan’s GDP fell from $5.45 trillion to $4.52 trillion between 1995 and 2007. Japan also used QE in 2012 when Prime Minister Shinzo Abe was elected and sought to stimulate the economy.

Quantitative Easing in the US

A few rounds of quantitative easing took place throughout the financial crisis from 2008 to 2011.

The most successful example of QE was the $2 trillion stimulus enacted by the U.S. in 2008, despite the fact that it doubled the national debt from $2.1 trillion to $4.4 trillion in just a few years. Although many feel that the QE program helped get the U.S. and global economy through the recession following the financial crisis, this topic has been debated and is hard to quantify.

Some critics argue that banks actually held on to much of the excess money they received through the QE program rather than lending it out, so the program didn’t exactly have the desired effect. However, QE helped to remove subprime mortgages from bank balance sheets and bring the housing market back.

Quantitative Easing in Switzerland

During the 2008 financial crisis, the Swiss National Bank also implemented a QE program. In terms of its ratio to GDP, the Swiss program was the largest ever enacted in the world.

Despite this overwhelming effort that resulted in some economic growth, Switzerland didn’t reach its inflation targets after the use of QE.

Quantitative Easing in the UK

In 2016, the Bank of England launched a QE program worth £70 billion to help alleviate economic concerns about Brexit.

Between 2016 and 2018, business investment grew in the U.K., but it was still growing at a slower rate than it had been in previous years. Economists have not been able to confirm whether growth would have been even slower without the QE program.

Pros and Cons of Quantitative Easing

While QE programs can help stimulate a struggling economy, they have some downsides, and there are reasons they are used as a last resort.

Pros of Quantitative Easing

• QE programs make it easier for businesses to take out loans.

• The influx of money into the market can help keep the economy flowing and release liquidity traps.

• Low interest rates make it easier for consumers to take out loans for cars, homes, and other borrowing needs.

• QE can be an important tool during a financial crisis in order to avert recession, or even severe economic depression.

Cons of Quantitative Easing

• Increasing the supply of money can lead to inflation.

• Stagflation can occur if the QE money leads to inflation but doesn’t help with economic growth. The Fed can’t force banks to lend money out and it can’t force businesses and consumers to take out loans.

• QE can devalue the domestic currency, which makes production and consumer costs higher.

• As a relatively new economic concept, there isn’t data and consensus about whether QE is effective.

What If QE Doesn’t Work?

Previous QE programs implemented by Japan, Switzerland, and the U.K. have not managed to reach the stimulus goals they set out to achieve. However, the QE program enacted in the U.S. during the 2009 recession helped to revive the housing market, stimulate the economy, and restore trust in banks. It didn’t cause rampant inflation as many feared it would.

It’s unclear how effective it was following stimulus measures implemented during the COVID-19 pandemic, too. As a relatively new strategy, there isn’t enough data to confirm whether QE is effective. In fact, there isn’t even agreement about how exactly it’s supposed to work.

Flattening the Yield Curve

Economists have a theory that quantitative easing will work by flattening the yield curve, which is a graph curve that displays the variation of interest rates according to their term of maturity. When the Fed purchases long-term Treasuries, their yield goes down and their prices go up.

This results in the yields of corporate bonds and long-term mortgages going down as well. Lower rates encourage home construction, corporate investment, and other activities that stimulate the economy. Although this sounds good in theory, the issue in the current economy is that the yield curve is already pretty flat.

Losing Effectiveness

A QE program might stimulate the economy for a short amount of time, but it could also lose its effectiveness. If this happens, the government can also turn to fiscal policy, or government spending, to further put money into the economy.

Sometimes QE and government spending can blur together, if the Fed purchases government bonds that are issued to fund government spending.

Some economists also believe that by signaling to the world that the Fed is serious about stimulating the economy, this will help create economic growth and spending and make consumers confident about making purchases. Whether this is true is yet to be seen in the current global situation.

The Takeaway

Quantitative easing is an unconventional monetary policy tool that central banks can use when faced with weak or nonexistent growth. Central banks typically resort to measures like QE when more conventional monetary policy tools, such as lowering interest rates, are no longer effective or not enough to stimulate an economy.

QE is a relatively new phenomenon, but it became more common after the 2008 financial crisis, when multiple central banks around the world resorted to asset purchases to boost economic growth.

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Sep

2023

What Is a Bear Market? Characteristics and Causes, Explained

By Laurel Tincher | Growing Wealth, invest, Investing | Comments Off

A bear market is defined as a broad market decline of 20% or more from recent highs, which lasts for at least two months. Although bear markets make for dramatic headlines, the truth is that bull markets tend to last much longer — the average bear market typically ends within a year.

While most investors know the difference between a bull and a bear market, it’s important to know some of the characteristics of bear markets in order to understand how different market conditions may impact your portfolio and your investment choices.

What Is a Bear Market?

Investors and market watchers generally define a bear market as a drop of 20% or more from market highs. So when investors refer to a bear market, it usually means that multiple broad market indexes, such as the Standard & Poors 500 Index (S&P 500), Dow Jones Industrial Average (DJIA), and others, fell by 20% or more over at least two months.

To be sure, 20% is a somewhat arbitrary barometer, but it’s a common enough standard throughout the financial world.

The term bear market can also be used to describe a specific security. For example, when a particular stock drops 20% in a short time, it can be said that the stock has entered a bear market.

Bear markets are usually associated with economic recessions, although this isn’t always the case. As economic activity slows, people lose jobs, consumer spending falls, and business earnings decline. As a result, many companies may see their share prices tumble or stagnate as investors pull back.

Why Is It Called a Bear Market?

There are a variety of explanations for why “bear” and “bull” have come to describe specific market conditions. Some say a market slump is like a bear going into hibernation, versus a bull market that keeps charging upward.

The origins of the term bear market may also have come from the so-called bearskin market in the 18th century or earlier. There was a proverb that said it is unwise to sell a bear’s skin before one has caught the bear. Over time the term bearskin, and then bear, became used to describe the selling of assets.

Characteristics of a Bear Market

There are two different types of bear markets:

• Regular bear market or cyclical bear market: The market declines and takes a few months to a year to recover.

• Secular bear market: This type of bear market lasts longer and is driven more by long-term market trends than short-term consumer sentiment. A cyclical bear market can happen within a secular bear market.

History of Bear Markets

The most recent U.S. bear market began in June 2022, largely sparked by rising interest rates and inflation. The bear market officially ended on June 8, 2023, lasting about 248 trading days, according to Dow Jones Market Data, and resulting in a market drop of about 25.4%.

Including the most recent bear market, the S&P 500 Index posted 12 declines of more than 20% since World War II. The table below shows the S&P 500’s returns from the highest point to the lowest point in a downturn. Bear markets average a decline of 34%, and generally last a little more than a year: about 400 days.

Recommended: What Is a Financial Crisis?

Bear markets have occurred as close together as two years and as far apart as nearly 12 years. A secular bear market refers to a longer period of lower-than-average returns; this could last 10 years or more. A secular bear market may include minor rallies, but these don’t take hold.

A cyclical bear market is more likely to last a few weeks to a few months and is more a function of market volatility.

Peak (Start)	Trough (End)	Return	Length (in days)
May 29, 1946	May 17, 1947	-28.78%	353
June 15, 1948	June 13, 1949	-20.57%	363
August 2, 1956	October 22, 1957	-21.63%	446
December 12, 1961	June 26, 1962	-27.97%	196
February 9, 1966	October 7, 1966	-22.18%	240
November 29, 1968	May 26, 1970	-36.06%	543
January 11, 1973	October 3, 1974	-48.20%	630
November 28, 1980	August 12, 1982	-27.11%	622
August 25, 1987	December 4, 1987	-33.51%	101
March 27, 2000	Sept. 21, 2001	-36.77%	545
Jan. 4, 2002	Oct. 9, 2002	-33.75%	278
October 9, 2007	Nov. 10, 2008	-51.93%	408
Jan. 6, 2009	March 9, 2009	-27.62%	62
February 19, 2020	March 23, 2020	-34%	33
June 2022	June 8, 2023	-25%	248
Average		-34%	401

Source: Seeking Alpha/Dow Jones Market Data as of June 8, 2023.

What Causes a Bear Market?

Usually bear markets are caused by a loss of consumer, investor, and business confidence. Various factors can contribute to the loss of consumer confidence, such as changes to interest rates, global events, falling housing prices, or changes in the economy.

When the market reaches a high, people may feel that certain assets are overvalued. In that instance, people are less likely to buy those assets and more likely to start selling them, which can make prices fall.

When other investors see that prices are falling, they may anticipate that the market has reached a peak and will start declining, so they may also sell off their assets to try and profit on them before the decline. In some cases panic can set in, leading to a mass sell-off and a stock market crash (but this is rare).

Is a Recession the Same as a Bear Market?

No. Bear market conditions can lead to recessions if the market slump lasts long enough. But this isn’t always the case. According to the National Bureau of Economic Research as reported in The New York Times, the U.S. has been in a recession only 14% of the time since World War II.

What Is a Bear Market Rally

Things can get tricky if there is a bear market rally. This happens when the market goes back up for a number of days or weeks, but the rise is only temporary. Investors may think that the market decline has ended and start buying, but it may in fact continue to decline after the rally. Sometimes the market does recover and go back into a bull market, but this is hard to predict.

If the bear market continues on long enough then it becomes a recession, which can go on for months or years. That said, it’s not always the case that a bear market means there will be a recession.

Once asset prices have decreased as much as they possibly can, consumer confidence begins to rise again, and people start buying. This reverses the bear market trend into a bull market, and the market starts to recover and grow again.

Example of a Bear Market

The most recent bear market occurred in June of 2022, when the S&P 500 closed 21.8% lower than its high on Jan. 3, 2022.

While the Nasdaq and the Dow showed a similar pattern in early 2022, the decline of those markets didn’t cross the 20% mark that signals official bear market territory.

Bear Market vs Bull Market

A bull market is essentially the opposite of a bear market. As consumer confidence increases, money goes into the markets and they go up.

A bull market is defined as a 20% rise from the low that the market hit in a bear market. However, the parameters of a bull market are not as clearly defined as they are for a bear market. Once the bottom of the bear market has been reached, people generally feel that a bull market has started.

Investing Tips During a Bear Market

There are a few different bear market investing strategies one can use to both prepare for a bear market and navigate through one.

1. Reduce Risky Investments

When preparing for a bear market, it’s a good idea to reduce riskier holdings such as growth stocks and speculative assets. One can move money into cash, gold, bonds, or other ‘safe’ investments to reduce the risk of losses if the market goes down.

These safe investments tend to perform better than stocks during a bear market. Types of stocks that tend to weather bear markets well include consumer staples and healthcare companies.

2. Diversify

Another investing strategy is diversification. Rather than having all of one’s money in stocks, distribute your investments across asset classes, e.g. precious metals, bonds, crypto, real estate, or other types of investments.

This way, if one type of asset goes down a lot, the others might not go down as much. Similarly, one asset may increase a lot in value, but it’s hard to predict which one, so diversifying increases the chances that one will be exposed to the upward trend, and you’ll see a gain.

3. Save Capital and Reduce Losses

During a bear market, a common strategy is to shift from growing capital into saving it and reducing losses. It may be tempting to try and pick where the market has hit the bottom and start buying growth assets again, but this is very hard to do. It’s safer to invest small amounts of money over time using a dollar-cost averaging strategy so that one’s investments all average out, rather than trying to predict market highs and lows.

4. Find Opportunities for Future Growth

However, in a broad sense if the market is at a high and assets are clearly overvalued, this may not be the best time to buy. And vice versa if assets are clearly undervalued it may be a good time to buy and grow one’s portfolio. A bear market can be a good time to identify assets that might grow in the next bull market and start investing in them.

5. Short Selling

A very risky strategy that some investors take is short selling in anticipation of a bear market. This involves borrowing shares and selling them, then hoping to buy them back at a lower price. It’s risky because there is no guarantee that the price of the shares will fall, and since the shares are borrowed, typically using a margin account, they may end up owing the broker money if their trade doesn’t work out as they hope.

Overall, it’s best to create a long-term investing strategy rather than focusing on short-term trends and making reactive decisions to market changes. It can be scary to watch one’s portfolio go down, especially if it happens fast, but selling off assets because the market is crashing generally doesn’t turn out well for investors.

The Takeaway

Bear markets can be scary times for investors, but even a prolonged drop of 20% or more isn’t likely to last more than a few months, according to historical data. In some cases, bear markets present opportunities to buy stocks at a discount (meaning, when prices are low), in the hope they might rise.

Also there are strategies you can use to reduce losses and prepare for the next bull market, including different types of asset allocation. The point is that whether the markets are considered bearish or bullish, any time can be a good time to invest.

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FAQ

How long do bear markets last?

Bear markets may last a few months to a year or more, but most bear markets end within a year’s time. If they go on longer than that they typically become recessions. And while a bear market can end in a few months, it can take longer for the market to regain lost ground.

When was the last bear market?

The most recent bear market started in June of 2022, when the S&P 500 fell from record highs in January for more than two months.

Photo credit: iStock/Morsa Images

Sep

2023

Is Inflation a Good or Bad Thing for Consumers?

By Rebecca Lake | Growing Wealth, invest, Investing | Comments Off

There are two sides to inflation for consumers: The rising cost of goods and services means that the basic cost of living rises for most people. But the right amount of inflation can spur production and economic growth.

Deciding whether inflation is good or bad therefore depends on how various factors might play out in different economic sectors.

What Is Inflation?

Inflation is an economic trend in which prices for goods and services rise over time. The Federal Reserve uses different price indexes to track inflation and determine how to shape monetary policy.

Generally speaking, the Fed targets a 2% annual inflation rate as measured by pricing indexes, including the Consumer Price Index. Historically, though, the inflation rate has been about 3.3%.

Rising demand for goods and services can trigger inflation when there’s an imbalance in supply. This is known as demand-pull inflation.

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities.

Asking whether inflation is bad isn’t the right lens for this economic factor. Inflation can have both pros and cons for consumers and investors. Understanding the potential effects of inflation can maximize the positives while minimizing the negatives.

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Is Inflation Good or Bad?

Answering the question of whether inflation is good or bad means understanding why inflation matters so much. The Federal Reserve takes an interest in inflation because it relates to broader economic and monetary policy.

Some level of inflation in an economy is normal, and an indication that the economy is continuing to grow. While inflation has remained relatively low over the past decade, it has historically seen the most change during or right after recessions.

The Fed believes that its 2% target inflation rate encourages price stability and maximum employment.

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Broadly speaking, high inflation can make it difficult for households to afford basic necessities, such as food and shelter. When inflation is too low, that can lead to economic weakening. If inflation trends too low for an extended period of time, consumers may come to expect that to continue, which can create a cycle of low inflation rates.

That sounds good, as lower inflation means prices are not increasing over time for goods and services. So consumers may not struggle to afford the things they need to maintain their standard of living. But prolonged low inflation can impact interest rate policy.

The Federal Reserve uses interest rate cuts and hikes to keep the economy on an even keel. For example, if the economy is in danger of overheating because it’s growing too rapidly, or inflation is increasing too quickly, the Fed may raise rates to encourage a pullback in borrowing and spending.

Conversely, when the economy is in a downturn, the Fed may cut rates to try to promote spending and borrowing.

When both inflation and interest rates are low, that may not leave much room for further rate cuts in an economic crisis, which may spur higher employment rates. If prices for goods and services continue to decline, that could lead to a period of deflation or even a recession.

So, is inflation good or bad? The answer is that it can be a little of both. How deeply inflation affects consumers or investors — and who it affects most — depends on what’s behind rising prices, how long inflation lasts, and how the Fed manages interest rates.

What Is Core Inflation?

Core inflation measures the rising cost of goods and services in the economy, but excludes food and energy costs. Food and energy prices are notoriously volatile, even though demand for these staples tends to remain steady.

Both food and energy prices are partly driven by the price of commodities — which also tend to fluctuate, owing to speculation in the commodities markets. So the short-term price changes in these two markets make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Who Benefits from Inflation?

The Federal Reserve believes some inflation is good and even necessary to maintain a healthy economy. The key is keeping inflation rates at acceptable levels, such as the 2% annual inflation rate target. Staying within this proverbial Goldilocks zone can result in numerous positive impacts for consumers and the economy in general.

That said, the core inflation rate began to climb out of that range in Q1 of 2021, and reached a peak of about 9.02% in June 2022. As of Q3 2023, the inflation rate has eased down in the 4.0% range, according to data from the Consumer Price Index.

Inflation Pros

Sustainable inflation can yield these benefits:

• Higher employment rates

• Continued economic growth

• Potential for higher wages if employers offer cost-of-living pay raises

• Cost-of-living adjustments for those receiving Social Security retirement benefits

The danger, of course, is that inflation escalates too rapidly, requiring the Federal Reserve to raise interest rates as a result. This increases the overall cost of borrowing for consumers and businesses.

Who Is Inflation Good For?

Inflation can benefit certain groups, depending on how it impacts Fed shapes monetary policy. Some of the people who can benefit from inflation include:

• Savers, if an interest rate hike results in higher rates on savings accounts, money market accounts or certificates of deposit

• Debtors, if they’re repaying loans with money that’s worth less than the money they borrowed

• Homeowners who have a low, fixed-rate mortgage

• People who hold investments that appreciate in value as inflation rises

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Who Does Inflation Hurt the Most?

Some of the negative effects of inflation are more obvious than others. And there may be different consequences for consumers versus investors.

Inflation Cons

In terms of what’s bad about inflation, here are some of the biggest cons:

• Higher inflation means goods and services cost more, potentially straining consumer paychecks

• Investors may see their return on investment erode if higher inflation diminishes purchasing power, or if they’re holding low-interest bonds

• Unemployment rates may climb if employers lay off staff to cope with rising overhead costs

• Rising inflation can weaken currency values

Inflation can be particularly bad if it leads to hyperinflation. This phenomenon occurs when prices for goods and services increase uncontrolled over an extended period of time. Generally, this would mean an inflation growth rate of 50% or more per month. While hyperinflation has never happened in the United States, there are many examples from different time periods around the world: For example, Zimbabwe experienced a daily inflation rate of 98% in 2007-2008, when prices doubled every day.

Recommended: How to Protect Yourself From Inflation

Who Is Inflation Bad For?

The negative impacts of inflation can affect some more than others. In general, inflation may be bad for:

• Consumers who live on a fixed income

• People who plan to borrow money, if higher interest rates accompany the inflation

• Homeowners with an adjustable-rate mortgage

• Individuals who aren’t investing in the market as a hedge against inflation

Inflation and higher prices can be detrimental to retirees whose savings may not stretch as far, particularly when health care becomes more expensive.

If the cost of living increases but wages stagnate, that can also be problematic for workers because they end up spending more for the same things.

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How to Invest During Times of Inflation

While inflation is an investment risk to consider, some investing strategies can help minimize its impact on your portfolio.

How to Protect Your Money From Inflation

The first step is to understand that inflation rates may be variable from year to year, but the upward trend in the cost of goods and services is typically a factor investors must contend with. Essentially, if inflation is historically about 2% per year, it’s ideal to look for returns above that.

For example, while savings accounts may yield more interest if the Fed raises interest rates, investing in stocks, exchange-traded funds (ETFs) or mutual funds could generate higher returns, though these investments also come with a higher degree of risk.

• Diversification. Having a diversified portfolio that includes a mix of stock and bonds and other asset classes may help mitigate the impact of inflation.

• Always be aware of investment costs and the impact of taxes and fees. Minimizing investment costs is a time-honored way to keep more of what you earn.

• Investing in Treasury-Inflation Protected Securities (TIPS). TIPS are government-issued securities designed to generate consistent returns regardless of inflationary changes.

• If prices are rising, that can increase rental property incomes. You could benefit from that by investing in real estate ETFs or real estate investment trusts (REITs) if you’d rather not own property directly.

• Compounding interest allows you to earn interest on your interest, which is key to building wealth.

• Dollar-cost averaging means investing continuously, whether stock prices are low or high. When inflationary changes are part of a larger shift in the economic cycle, investors who dollar-cost average can still reap long term benefits, despite rising prices.

The Takeaway

Inflation is unavoidable, but you can take steps to minimize the impact to your personal financial situation. Building a well-rounded portfolio of stocks, ETFs and other investments is one strategy for keeping pace with rising inflation. Being aware of how taxes and fees can impact your returns is another way to keep more of what you earn.

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FAQ

How is economic deflation different from inflation?

Deflation is when the cost of goods and services trends downward rather than upward (the sign of inflation). Deflation can be positive for consumers, as their money goes further, but prolonged deflation can also be a sign of a contraction.

How do homeowners benefit from inflation?

Typically tangible assets like real estate tend to increase in value over time, even in the face of inflation. Currency, on the other hand, tends to lose value.

How does the government measure inflation?

The Bureau of Labor Statistics produces the Consumer Price Index (CPI), based on the change in cost for a range of goods and services. The CPI is the most common measure of inflation.

Photo credit: iStock/AJ_Watt

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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Shares of ETFs must be bought and sold at market price, which can vary significantly from the Fund’s net asset value (NAV). Investment returns are subject to market volatility and shares may be worth more or less their original value when redeemed. The diversification of an ETF will not protect against loss. An ETF may not achieve its stated investment objective. Rebalancing and other activities within the fund may be subject to tax consequences.

Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

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Sep

2023

7 Factors That Cause Inflation

By Colin Dodds | invest, Investing, Preparing for Retirement | Comments Off

There are a number of factors that can cause inflation, including an increase in the cost of raw materials, an increase in the currency supply, and more. When the cost of goods and services rise over time, and consumers have to spend more to buy basic items, that’s considered inflation.

Inflation is an economic reality, but the government tries to regulate inflation so that it remains at a low but steady pace. The target is 2.0%, but historically it’s closer to 3.3%. A period of higher inflation began in early 2021, thanks in part to supply chain bottlenecks resulting from the pandemic.

Inflation isn’t necessarily a bad thing — it can also result from an economic upturn. But when the prices of goods and services rise in relation to the dollar, or the currency in use, the result is that each unit of currency will buy less of just about everything than it previously did.

Here’s a closer look at how to track inflation, and seven factors that cause prices to increase.

How to Track Inflation

The most commonly used measure to track inflation is the Consumer Price Index (CPI), which is produced by the U.S. Bureau of Labor Statistics (BLS) each month. The CPI tracks the average of prices of a set of goods and services. While the CPI leaves out important aspects of consumer spending, such as real estate and education, it is considered a valuable gauge of the ever-changing cost of living.

What Is Core Inflation?

Core inflation also measures the rising cost of goods and services, but it excludes food and energy costs. The reason being that both food and energy prices are partly driven by the price of commodities — which tend to be volatile, owing to speculation in the commodities markets. So the short-term price changes in food and energy make it difficult to include them in a long-term reading of inflationary trends: hence the core inflation metric.

The Consumer Price Index and the core personal consumption expenditures index (PCE) are the two main ways to measure underlying inflation that’s long term.

Inflation also shows up in the wholesale price index (WPI), which measures and tracks the changes in the price of commodities and other goods that are traded between businesses.

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Types of Economic Inflation

There are a range of different types of inflation, although they are fundamentally interrelated.

Cost-Push Inflation

Cost-push inflation occurs when the price of commodities rises, pushing up the price of goods or services that rely on those commodities. For example, owing to high demand for certain types of minerals used in technology equipment, the prices for those goods are likely to rise.

Demand-Pull Inflation

Rising demand for goods and services can trigger inflation when there’s an imbalance in supply vs. demand. This is known as demand-pull inflation. For example, if there’s a high demand for pork (or if there’s a slump on the supply side owing to pork shortages), that could drive up the price of bacon, ham, and other pork products.

Built-In Inflation

Built-in inflation is the result of an upward spiral in wages, as workers seek raises to keep up with the cost of living. This in turn can lead businesses to raise their prices, adding to the higher prices.

As you can see, these three types of inflation are connected through the loop of supply and demand.

Recommended: 5 Tips to Hedge Against Inflation

What Causes Inflation?

While inflation has become a persistent factor in most of the world’s economies, it can result from a range of different causes. Understanding the different causes can help investors manage inflation risk — i.e. the possibility that the money you invest won’t earn enough to keep up with inflation.

1. The Economy Is Going Strong

When the economy is growing, more people have jobs, wages increase in order to hire and keep those workers, and more people have money to spend. As a result, they buy more necessities and some even splurge on luxury items.

In this environment, businesses can increase their prices, and consequently, wholesalers can increase prices. The net result of this cycle of expansion is higher prices across the board: aka inflation.

This scenario is why inflation isn’t always bad news. In fact, the Federal Reserve aims for a target annual inflation rate of around 2%, because it indicates a growing economy. As noted above, this kind of inflation is a type of “demand-pull inflation,” because it is driven by consumer demand.

In fact, deflation — when the prices of goods fall for a period of time — can also be considered unhealthy because it can mean demand among consumers is weak.

2. There Is More Currency Available

Inflation can also occur when the Fed, or another central bank, adds fiat currency into circulation at a rate that exceeds that of the economy’s growth rate. That creates a situation in which there are more dollars bidding on fewer goods and services. The result is that goods and services cost more.

One reason that inflation has been a constant in the U.S. since 1933 is that the Fed has continually increased the money supply. In response to the 2008 financial crisis, the Fed dropped its lending rate close to zero as a way to inject more liquidity into the economy, which led to increased inflation but not hyperinflation. While those increases have usually moved in step with growth, that hasn’t always been the case.

In response to the Covid-19 pandemic and subsequent lockdowns, the Fed released the equivalent of $3.8 trillion in new liquidity in 2020. That amount was equal to roughly 20% of the dollars previously in circulation. And it is one reason why many investors were watching the CPI closely in 2021 — and were not surprised when inflation began to climb through 2022.

3. Basic Materials Increase in Price

In the 1970s in the U.S., inflation was rampant. There were many reasons for this, but one major one was the OPEC oil embargoes. The embargoes led to a gas shortage, higher prices for home-heating oil, higher prices at the pump, and increases in the prices of manufacturing and shipping for nearly every single consumer good.

Between 1973 and 1974, inflation-adjusted oil prices jumped from $25.97 per barrel to $46.35. And as a result, inflation topped 11% that year.

Another one of the most dramatic periods of inflation was the period of 1979-1981, when inflation topped 10% for three straight years. Again, oil was a major contributing factor, as the Iranian Revolution set off further increases in the price of oil.

Recommended: Guide to Investing in Oil

4. The Housing Market Takes Off

The housing market is a major part of the U.S. economy, and it has an outsized impact on the broader economy. When the housing market is strong and home prices are rising, then homeowners have more equity to call upon to make major purchases, which can goose inflation.

At the same time, a strong housing market means that homeowners, contractors, and builders are spending more on home improvements and buying the raw materials that make those new and improved homes possible. That, in turn, drives up the prices of those raw materials, such as steel, lumber, and oil, which can lead to more inflation.

💡 Quick Tip: Newbie investors may be tempted to buy into the market based on recent news headlines or other types of hype. That’s rarely a good idea. Making good choices shouldn’t stem from strong emotions, but a solid investment strategy.

5. The Government Implements Expansionary Fiscal Policies

The federal government will occasionally try to jumpstart economic growth with new policies. These expansionary fiscal policies often seek to increase the amount of discretionary income that businesses and consumers have to spend.

Often, these policies take the form of reduced taxes with the belief that businesses will spend it on employee compensation and new hiring. That will allow more consumers to spend on goods and services.

Other times, those policies consist of massive infrastructure projects, which can increase the demand for goods and services. The increasing of overall liquidity due to central bank monetary policy is also considered an expansionary policy.

6. New Regulations Increase Costs

While a shortage of an essential commodity, like oil, can cause inflation, so can an increase in costs related to a commodity suddenly becoming more expensive because of government regulations.

Sometimes new tariffs can increase the costs of imported goods, which can lead to inflation. At the same time, new regulations that make a particular commodity or service more expensive or time-consuming to obtain can also increase the costs to consumers, leading to inflation.

7. The Exchange Rate Changes

The value of the U.S. dollar in relation to all other foreign currencies is constantly in flux. If the dollar goes down, then imported commodities and consumer goods get more expensive. But it also makes goods exported from the U.S. cheaper abroad, which can actually be a boost for the economy.

The Takeaway

Inflation in the U.S. has been a constant since 1933. Most years inflation is a slow drip of almost imperceptible price increases, but there have been times when it has risen sharply, as it did during the late 70s and early 80s. This was a painful period for many consumers and inflation became a major political issue.

Inflation was fairly gradual in the decades since then, but after stimulus packages during the Covid-19 pandemic and a reopening of the economy boosted prices and growth, inflation took off. It reached a peak of about 9.02% in June of 2022, and has eased down closer to the historical average of about 3.28% throughout 2023.

The forces that can stir or mitigate inflation are important for investors to understand. Managing your investment strategy in light of the inevitable impact of inflation can help offset inflation risk — the risk that your money won’t retain its purchasing power in the future.

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FAQ

How does raising interest rates help inflation?

Higher interest rates may help slow spending, because the cost of borrowing increases as rates rise. People may also be inclined to take advantage of higher rates by saving more, which can also slow demand and cool the economy.

How quickly does inflation decrease to normal levels?

Cycles of inflation historically have lasted many years, or a couple of months. How quickly inflation subsides depends on economic conditions overall, as well as the origins of a particular bout of inflation. If employment numbers change, if interest rates rise or fall, if demand overshoots supply — these are among the factors that can influence inflation.

Who benefits from inflation?

There are a couple of scenarios where inflation can be beneficial. For example, those with bigger debts can benefit from inflation because the money they’re using to pay off their car or home loan, say, is now less valuable than the money they borrowed. Those working in jobs made more secure by rising demand can also benefit. In some cases, holding foreign currency may be more beneficial in relation to the inflationary currency. Inflation is fluid, and it’s important to gauge which factors are at play before deciding what is beneficial or not.

Who is hurt most by inflation?

Lower-income households are disproportionately affected by inflation, because the cost of goods and services is rising faster than wages. Another group hit hard by inflation is retirees and those living on fixed incomes, because their money is buying less over time.

Photo credit: iStock/Delmaine Donson

Sep

2023

How Dark Pools Operate – and Why They Exist

What Is a Dark Pool in Trading?

By Colin Dodds | Growing Wealth, invest, Investing, Terminology | Comments Off

Dark pools, sometimes referred to as “dark pools of liquidity,” are a type of alternative trading system used by large institutional investors to which the investing public does not have access.

Living up to their “dark” name, these pools have no public transparency by design. Institutional investors, such as mutual fund managers, pension funds, and hedge funds, use dark pool trading to buy and sell large blocks of securities without moving the larger markets until the trade is executed.

Understanding the History of Dark Pools

The history of dark pools in the trading world starts in the 1980s, following changes at the Securities and Exchange Commission (SEC) which effectively allowed brokers to make trades in large share blocks. Later, in the mid-2000s, further SEC changes that were meant to cut trading costs and increase market competition led to an increase in dark pool trading.

Dark Pool Examples

There are many dark pools out there, and they can be operated by independent companies, brokers or broker groups, or stock exchanges themselves. An internet search would bring up names of specific dark pools.

But to get a sense of how a dark pool can be used to investors’ benefit, say there’s a mutual fund looking to sell 2 million shares of Stock X. Given that selling that amount of shares would create ripples in the market, the mutual fund may not want to sell them all at once. As such, they sell them in blocks of 10,000, 1,500, or 5,000 shares — and find buyers for the smaller blocks accordingly.

This method makes it less obvious that a huge number of shares are being sold, which could avoid Stock X’s shares losing value quickly.

Who Runs Dark Pools?

Investment banks typically run dark pools, but some other institutions run them as well, including large broker-dealers, agency brokers, and even some public exchanges. Some trading platforms, where individual investors buy and sell stocks, also use dark pools to execute trades using a payment for order flow.

Recommended: What Is a Market Maker?

The role of dark pools in the market varies over time. At times, dark pool trades comprise as much as half of all trading in a single day, while at other times, they make up significantly less of U.S. equity volume.

Because trades in a dark pool aren’t reflected in the prices on a public exchange, participants in a dark pool trade based on the prices offered on a public exchange, using the midpoint of the National Best Bid and Offer (NBBO) to set prices.

💡 Quick Tip: Look for an online brokerage with low trading commissions as well as no account minimum. Higher fees can cut into investment returns over time.

Why Institutions Use Dark Pools

Large, institutional investors such as hedge funds, may turn to dark pools to get a better price when buying or selling large blocks of a single stock. That’s because of the way that large trades impact the public markets.

As discussed, if a mutual fund manager, for example, wants to sell a million shares of a given stock because it’s underperforming or no longer fits their strategy, they’d need to use a floor trader to unload the position on a public exchange. Selling all those shares could impact the price they get, driving down the VWAP (volume weighted average price) of the total sale.

To avoid driving down the price, the manager might spread out the trade over several days. But if other traders identify the institution or the fund that’s selling they could also sell, potentially driving down the price even further.

The same risk exists when buying large blocks of a given security on a public market, as the purchase itself can attract attention and drive up the price.

New Risks

The risks of attracting attention from other traders have intensified with the rise of algorithmic trading and high-frequency trading (HFT). These strategies employ sophisticated computer programs to make big trades just ahead of other investors. HFT programs flood public exchanges with buy or sell orders to front-run giant block trades, and force the fund manager in the above example to get a worse price on their trade.

Dark Pool Benefits

Utilizing a dark pool and conducting a dark trade, institutional investors can sell a million shares of a stock without the public finding out because dark pool participants don’t disclose their trades to participants on the exchange. The details of trades within a dark pool only show up after a delay on the consolidated tape — the electronic system that collates price and volume data from major securities exchanges.

There are other advantages for an institutional trader. Because the buyers and sellers in a dark pool are other institutional traders, a fund manager looking to sell a million shares of a given stock is more likely to find buyers who are in the market for a million shares or more. On a public exchange, that million-share sale will likely need to be broken up into dozens, if not hundreds of trades.

Criticism of Dark Pools

As dark pools have grown in prominence, they’ve attracted criticism from many directions, and scrutiny from regulators. For instance, the lack of transparency in dark pools and the exclusivity of their clientele makes some investors uneasy. Some even believe that the pools give large investors an unfair advantage over smaller investors, who buy and sell almost exclusively on public exchanges.

The Takeaway

As discussed, dark pools are sometimes referred to as “dark pools of liquidity,” and are a type of alternative trading system used by large institutional investors to which the investing public does not have access. They’re typically run and utilized by large investment banks.

Given the nature of dark pools, they attracted criticism from some due to the lack of transparency, and the exclusivity of their clientele. While the typical investor may not interact with a dark pool, knowing the ins and outs may be helpful background knowledge.

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FAQ

How can you see dark pool trades?

Investors can access dark pool trading data through various securities information processors, and can be accessed through FINRA’s website as well.

Who regulates dark pools?

The Securities and Exchange Commission, or SEC, is the government body that regulates dark pools and dark pool trading.

What are dark pools in cryptocurrency?

A dark pool in cryptocurrency is more or less the same as a dark pool in other equities markets, and is a place that matches buyers and sellers for large orders outside of a public exchange or view.

How do dark pools differ from lit pools?

As many might surmise, lit pools are effectively the opposite of dark pools, in that they show trading data such as number of shares traded and bid/ask prices.

Photo credit: iStock/DNY59