More than anything else, the financial markets are driven by fear.  Investors fear large, unexpected moves in the markets.  They fear missing out on opportunities.  And, most of all, they fear losing money.

Of course, fear becomes a real factor in the financial markets when a major crisis occurs, such as the bank bailouts in 2008.  Fortunately, these types of events don’t happen all that often.

On a more consistent basis, nothing generates investor fear like the threat of inflation.  Year after year, analysts and experts of all kinds warn of the adverse effects inflation can have on an investment portfolio.

Basically, inflation means the costs of goods and services are rising over a period of time.  As such, each dollar you earn can purchase less and less of those goods and services.

So what makes inflation such a big deal?

Well, if your income level doesn’t keep up with the pace of inflation, you’re essentially taking a pay cut when inflation occurs.  On a limited basis, it’s not a major concern. However, over a long period of time or in large amounts, inflation can be a real issue.

What’s more, severe inflation can lead to social unrest and other major sociopolitical issues.  Clearly, that’s the kind of stuff no one wants to deal with.

With that in mind, you might be wondering if the recent Fed stimulus is a reason to worry about inflation.  After all, many of those critical of the Fed have been citing inflation concerns.  Their argument is that with the Fed “printing” so much money, it will devalue the dollar to the point of significantly eroding our purchasing power.

Here’s the deal with the recent round of quantitative easing (QE3): yes, it should result in some inflation.  However, it’s actually supposed to create inflation.  You see, a certain amount of inflation is actually good for the economy – especially during a recession.

Let me explain…

There are actually several positive benefits to inflation when it is sits at a reasonable level (from 2% to 4% depending on overall economic conditions).

First off, reasonable inflation levels benefit the labor market.  The thing is, companies don’t like lowering wages because it upsets the workforce.  Instead, they can let inflation do their work for them.

Without getting too technical, companies can leave wages flat in tougher periods and inflation will function as a sort of pay cut.  Eventually, this means companies can hire more workers sooner than if inflation wasn’t occurring.

Second, inflation means money sitting in the bank is losing its purchasing power.  So, it makes sense for companies to go spend that money on capital investments, such as plants and equipment.  This capital spending then leads to economic growth.

Finally, when inflation is occurring, it means deflation is being avoiding. Deflation is very bad, even worse than high levels of inflation.  Just think of the Great Depression versus the high inflation of the 1970’s.  Everyone agrees the Great Depression was far worse than the 70’s.

What’s more, the Fed has a good track record of dealing with high inflation – particularly over the last 25 years.  On the other hand, a deflationary spiral is much harder to recover from.

Here’s why this is important to investors…

The first two reasons I mentioned about how inflation can be good are also good for your portfolio.  If a company is doing well enough to hire more workers or purchase capital goods, it should also be posting higher earnings.  And of course, that should translate to a higher stock price.

Let me break that down a bit further.

Suppose we’re in a recession or slow growth period with inflation running a modest 2%.  A company that makes widgets will raise the price of their widgets in line with inflation.  However, they’re holding labor costs steady due to the recession.  That means higher revenues with roughly stable costs (yes, materials costs will also rise, but in most cases labor is the far greater expense).

So what does higher revenue mean if costs stay the same?  Bigger profits.

Now, let’s say our widget company also has $100 million in the bank just sitting there.  If inflation is at 2% and short-term interest rates are paying 1%, then the company is effectively losing money.

So what will they do?  Well, they could buy another widget factory, buy more advanced equipment, acquire another company, expand into a new product, and more.  The payoff from these types of activities is almost certainly higher than what they’d earn saving the money.

Of course, any sort of expansion or addition to the company should result in higher revenues – and likely higher profits as well.  And, that’s exactly what investors are looking for when they buy stocks – in other words, higher stock prices.

Keep in mind, the benefits of inflation have an overarching effect on a portfolio as a whole.  Over time, it will benefit a cross section of companies.  It’s not necessarily the sort of reasoning investor use when purchasing one specific stock.  However, since most investors’ portfolios contain multiple stocks or mutual funds, healthy inflation is a positive for a vast majority of investors.

Bottom line, inflation isn’t nearly as bad as many investors think, especially during a recession.  Just keep an eye on inflation expectations.  As long as the number doesn’t exceed 3% to 4%, there’s nothing to worry about.  Even better, it should actually benefit your portfolio over time.

Jay Soloff

Jay Soloff

Jay currently writes for several popular websites specializing in small cap stocks, options, commodities, and more. Jay graduated from the University of Illinois with a degree in economics and has an MBA from Arizona State University. He now lives in Gilbert, Arizona with his wife and two children.