Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.
Every month, the Bureau of Labor Statistics releases the latest update on the prices that consumer pay for a wide range of products and services. Yet with the Consumer Price Index having been so low for so long, some wonder whether we'll ever again see the inflationary pressure that drove the Dow Jones Industrials (^DJI +1.79%) and other stock markets to poor performance in the 1970s and early 1980s. What many investors don't realize, though, is that the stocks of the Dow Jones Industrials actually give them at least some protection against inflation that bonds and many other investments lack.
Why inflation has been a non-issue lately
Today's news that the CPI rose 0.1% is consistent with the relatively tame inflation that we've seen for years. In the aftermath of the financial crisis, price levels stopped rising entirely for a couple of years, with actual deflation in certain months. That had an impact on millions of Americans whose wages or Social Security benefits are linked to the CPI, with retirees in particular seeing no cost-of-living adjustments for either 2009 or 2010.
Many economists have looked at the lack of wage increases as one reason why inflation has stayed low. Despite efforts from the Federal Reserve to add liquidity to the financial system and spur what in ordinary times might be inflationary pressures, employment gains have been tepid at best, with falling unemployment rates stemming more from an exodus of participants from the labor force than from strong job creation. Moreover, with the Fed now starting to ease off on its stimulus activities, the danger of inflation looks smaller than ever.
Don't declare inflation dead yet
The Fed's diligence in targeting a 2% inflation rate strongly suggests that the central bank would make every effort to fight inflation if it comes back. As the economy strengthens, demand for skilled labor should increase, putting workers in a better position to get higher wages and creating competition among employers for the best employees. If higher wages filter through the entire economy -- as it has in certain areas of the country where economic activity is at its strongest -- then inflation could become a threat again.
But the reason why Dow investors shouldn't worry as much about inflation is that many of its component stocks have the pricing power to pass through cost increases to customers. For instance, consumer-brand giant Nike (NKE +0.72%) already commands a high premium for its finished products compared to its costs of production, and so inflation can actually provide cover for the athletic-apparel maker to raise prices and boost margins.
Inflation also spurs corporate customers to find ways to cut costs, and that can help the companies that provide more efficient solutions. Boeing (BA +1.95%) is a good example, as the aircraft maker has already reaped big rewards from airlines seeking to cut their fuel costs by ordering new, more fuel-efficient models. A high-inflation environment could accelerate that trend, helping Boeing justify raising prices on its aircraft in order to meet higher production costs.
Of course, not every stock in the Dow benefits from inflation. Wal-Mart (WMT +2.19%), for instance, could see some gains from new customers looking for ways to economize in a rising-price environment. But rising supply costs could force it to raise its prices to maintain its already razor-thin margins, and that could alienate customers at the time when they need the retailer's low-cost promise the most.
Keep watching
Inflation might be subdued for now, but you should still remain diligent in tracking the CPI and other measures of inflation. Even though it's been a long time since high inflation hit the economy, those who remember its effects know all too well why it's worth the effort to keep it in check.
