If Surging Inflation Triggers a Market Crash, History Says Investors Should Do This 1 Thing First

On Tuesday, the Bureau of Labor Statistics reported that consumer prices climbed by a higher-than-expected 0.4% in October. Meanwhile, annual inflation was 3.7% for the year ending in September, well above the Federal Reserve's 2% target.

Fed officials have started sounding alarms. Chicago Fed President Austan Goolsbee told PBS the data was "borderline disturbing," and said tariff-driven price pressure isn't fading as he expected. Fed Gov. Christopher Waller said a 50-basis-point (0.5%) hike should be considered in December.

In the wake of these and other statements, CME's (NASDAQ:CME) FedWatch tool put the odds of a 25-basis-point hike at 86.8% on Wednesday, with the remaining 13.2% on a half-point move.

That's a notable shift. After three full years spent without raising rates, a December hike would be the Fed's second in four months. And with inflation proving stickier than the Fed had hoped, it may have to push rates much higher than markets expect. Stocks would have to compete with those higher yields, which could easily trigger a downturn or even a major crash.

But if such a crash happens, how should investors react? Here's what history says to do ... and what it says not to do.

Image source: Getty Images.

Here's what history says to do first

It may sound counterintuitive, but the first thing investors should do in response to an inflation-triggered market crash is:

Nothing.

The temptation to get out before stocks fall further is strong. But selling once a crash has already begun usually means locking in your losses. Plus, investors who sell during a crash often wait until a recovery is clearly underway to get back in, and the market's biggest gains often come before the all-clear sounds.

Inflation-driven sell-offs are different

Crashes caused by inflation don't usually look like the sharp, short-lived plunges of 2020's COVID crash or 2025's "Liberation Day" plunge. In those cases, policymakers could ride to the rescue quickly. When inflation is the illness, the Fed's primary medicine -- higher interest rates -- is part of what's keeping stock prices down, so relief can take longer.

The most recent example of this occurred in 2022. The S&P 500 (SNPINDEX:^GSPC) fell about 25% as the Fed hiked rates aggressively that year to combat massive inflation. The market bottomed in October 2022 while inflation was still far above the Fed's target. It even started hitting new highs in January 2024, when inflation was still at 3.4%. In other words, investors who waited for inflation to be clearly beaten would have missed much of the recovery.

Research from The Motley Fool also shows the market usually starts making big gains before a recession ends. That matters here, because a Fed determined to crush inflation could tip the economy into one.

Cash isn't always a safe haven

Investors who sell during a market downturn often keep their money in cash because it feels safer. But in an inflationary environment, cash may be the worst place to keep your money.

Any investment that earns less than the inflation rate loses purchasing power every day it sits on the sidelines. In a period of high inflation, it loses value that much more quickly.

Image source: Getty Images.

That makes the "sell now, buy back later" market crash plan doubly risky. While an investor waits to reenter the market, their cash pile is quietly shrinking due to inflation. Stocks, by contrast, may go up and down, but usually grow in value over time.

Then, check what you own

Staying put doesn't mean ignoring your portfolio.

2022 showed that stocks and bonds can fall together when inflation is the culprit, so a diversified portfolio matters more than ever. A calmer moment is a good time to check that you aren't concentrated in a single sector, and to consider whether you own businesses with real pricing power.

Of course, there's no way to predict when a crash will occur or how long a bear market might last. But history says that staying invested in a diversified portfolio is the most likely path to long-term success, inflation or no inflation.

John Bromels has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends CME Group. The Motley Fool has a disclosure policy.