Could Stagflation Come Back?

The Downside with Bearemy Glaser is markets editor Jeremy Glaser's worry-prone alter-ego's weekly look at issues that have been bugging him recently. Check out the first part of last week's column for more info.

Stagflation is not a word that many readers would ever want to see again, but unfortunately it looks like the possibility of a period of rapid rise in prices coupled with anemic growth could be upon us.

I'm certainly not the only one worried about inflation and its potential impact on the economy. Heather Brilliant, Morningstar's vice president of global equity and credit research, wrote this week in her outlook for the market that inflation, particularly in food and energy prices is taking hold. Morningstar's director of economic analysis, Bob Johnson, also sees inflation heating up in the months ahead.

But it isn't just Morningstar pundits that are becoming concerned. The Reuters/University of Michigan consumer sentiment survey asks responders for their expectations for future inflation, and consumers are expecting a hefty hike in prices. For the next year, expectations indicate a 4.6% rise, and the five-year expectations are sitting at 3.2%. This is much higher than the almost nonexistent inflation we've gotten used to during the last few years.

The official data is also starting to look gloomier. The government reported a 6% annualized rate of increase in the consumer price index for February, though that number drops to 2.4% excluding food and energy prices.

A rise in inflation could have deleterious effects on growth and all sorts of issues that are important to investors. I've highlighted three below but would love to know what you think the potential impact of higher inflation could be. Add your thoughts in the comments below.

Fed's Hands Get Tied
The Federal Reserve has a dual mandate to keep price levels in check and seek maximum employment in the economy. A benign inflation number has allowed the Fed to focus exclusively on maximum employment since the start of the crisis. In fact, the central bank has been the primary driver of stimulative policy recently as Congress' appetite to pull the fiscal level has waned. Chairman Ben Bernanke took the federal-funds rate close to zero in 2008 and has kept it there since. The Fed has also pumped money into the economy through quantitative easing and other programs.

The aggressiveness of the Fed's response to the recession is a sign that it would rather err on the side of having too loose of a policy than one that is too tight. I personally think that Bernanke would love nothing more than to keep rates low until the recovery has truly and completely taken hold. But if inflation starts to heat up, he is going to have start looking at the other side of the dual mandate. That means potentially raising rates or at least ending quantitative easing early in an attempt to keep price levels in line. This could have a negative impact on the still-fragile recovery.

Certainly monetary policy eventually has to move on from these extraordinary levels, but I wish it could happen on the Fed's terms instead of Bernanke being forced to act as a result of rising prices.

Margin Compression
Inflation isn't going to be good for the profitability of the vast majority of firms. Rising input costs wouldn't be a huge worry if firms were able to pass those higher prices along to consumers. Unfortunately, that could be very difficult in this environment. The consumer has come back but is still in a tenuous position and is hesitant to accept higher prices. Many firms may find that they have to eat most of the increase in costs which could mean a big hit to the bottom line. Corporate profitability has been a bright spot throughout the recovery, but a sharp reduction in profits won't help the recovery at all. It could lead to a reduction in corporate reinvestment and potentially make all sorts of firms more timid.

Of course the impact will be uneven across industries. Some, such as the airlines, could be hit especially hard as oil prices rise, while others with strong pricing power may be able to escape relatively unharmed.

Emerging-Markets Consumers May Slow Down
Emerging-markets consumers will be some of the hardest hit by rising food and energy prices in particular. A large share of consumers' budgets in emerging markets are allocated to basic needs such as food and heat. As it costs more to heat homes or feed families, there is even less to spend on other goods.

Emerging markets have been some of the strongest performers during the recovery, and many in developed markets were hoping that the consumers were ready to really open up their wallets and start spending. The basic idea was that higher spending would help boost exports from places like the United States and help ease global trade imbalances. These hopes look like they will be dashed if global inflation takes hold and emerging middle classes are forced to stop spending.

Other Issues at Stake
There are obviously many more impacts from higher inflation. Thinking about how higher price levels and possibly higher rates will affect fixed-income investing could fill many tomes on its own. And some sectors (energy comes to mind) may end up being net winners.

Are you worried about the impact of inflation? Do you think inflation isn't coming at all? What industries will see the biggest impact? Are you making any changes in your portfolio? Please share your thoughts below.