Inflation: It’s back, but will it last?
The challenges related to economic forecasting and reporting are many, not the least of which being the inherent impossibility of predicting the future. It’s also inherently true that various economic data points often paint a seemingly inconsistent — or at least very nuanced — picture. Even when the data is largely positive about one aspect of the economy, other data may simultaneously suggest cause for concern.
Such is the case today. Most data points to an economy that is growing at a rapid pace and appears poised to maintain an above-trend pace of growth in the coming quarters, with many forecasts suggesting that 2021 could yield the strongest in many decades in the United States. Given the massive fiscal stimulus injected into the economy over the past year, with much still sitting in bank accounts waiting to be spent, that optimistic outlook isn’t surprising. That’s good news for an economy that’s still trying to push through some of the lingering effects of the COVID-19 recession and for millions of Americans that haven’t yet returned to the ranks of the employed.
Along with that strong growth comes certain concerns, perhaps most notably around inflation. There’s no question that prices aren’t only rising but at an accelerating pace that’s the fastest in many years. Although the magnitude of the increase may have exceeded forecasts, the recent surge in the Consumer Price Index and other inflation gauges was widely expected — and not simply because of the massive injection of stimulus. As the economy recovered, rising inflation was inevitable. At this time a year ago, the economy was starting to stabilize after a historically steep and rapid slide that also dragged prices sharply lower for most goods and services. As the collapse in demand ultimately was reversed by the start of a historically noteworthy growth surge in Q3 last year, prices also began to bounce back from exceptionally weak levels.
Although the magnitude of the increase may have exceeded forecasts, the recent surge in the Consumer Price Index and other inflation gauges was widely expected.
Rising prices aren’t unusual as economies recover, but the speed of the pickup in spending, fueled by over $5 trillion of fiscal stimulus (equal to about 25% of GDP), was unprecedented. That surge in demand alone would be expected to lift prices. But recent inflationary pressures extended beyond strong demand and were significantly exacerbated by substantial constraints on the supply side of the economy. Supply chain bottlenecks, transportation disruptions, growing shortages of many raw materials, and slim inventories have collectively contributed to rising prices.
For businesses, the constraints aren’t limited to tangible goods. Employers are also experiencing a surprisingly challenging employment environment that has left many businesses struggling to hire workers to keep pace with demand. This may seem surprising with job openings at record levels and nearly 10 million Americans still unemployed. Three key factors may account for much of the disconnect: lingering concerns associated with health risk, the lack of availability of childcare and remote schooling, and enhanced unemployment benefits that exceed the market wage for many job openings. Each represents a disincentive for unemployed workers to return to the workforce, but also acts as a real obstruction to businesses attempting to hire to meet their growing needs. The result? More upward pressure on prices.
So, after a decade that was often dominated by concerns about the risk of deflation, inflation has reared its ugly head as a concern. Looking forward, the question is clear: how great is the risk presented by the recent surge in prices? Are we seeing the first signs of an extended period of higher prices, or are they a reflection of temporary imbalances in the global economy? These are complex questions, but ones that may be best addressed by evaluating the primary catalysts and considerations over specific time frames.
But recent inflationary pressures extended beyond strong demand and were significantly exacerbated by substantial constraints on the supply side of the economy.
The consensus view is that inflation pressures could continue to edge higher in the coming months. Demand is still robust, and there’s still over $3 trillion in cash sitting in checking accounts ($2 trillion more than in late 2019). The ongoing decline in COVID-19 risks and concurrent reopening of the economy should enable more Americans to engage in more activities — and that means more spending in the pipeline over the latter half of the year. At the same time, the previously mentioned supply disruptions and constraints on production aren’t likely to be as easily resolved, and it will take some time for the supply side of the economy to catch up with demand and rebuild inventories. This will certainly happen in phases for different goods and services. Prices for a range of services (travel, leisure, entertainment, for example) haven’t fully recovered to pre-pandemic levels and are expected to continue to rise. Conversely, there are some signs of prices easing for certain raw materials in recent weeks, although it’s far too soon to conclude that further price increases won’t occur.
The consensus view of most economists and the Fed is that the current pickup in inflation is caused by transitory factors and prices should begin to recede sometime next year, if not sooner. However, it’s also quite possible that inflation measures could remain higher than was the norm over the past decade, when even exceptionally subdued interest rates, half-century low unemployment, and a record-breaking decade of expansion was insufficient to push the consumer price inflation sustainably above 2%. The fact is that inflation was exceptionally and unusually low in the aftermath of the global financial crisis — an anomaly compared to other expansions. A return to a moderately higher trend inflation rate of 2.0–2.5% (measured by the CPI) wouldn’t be surprising or problematic. In fact, the Fed is openly banking on this. The risk, of course, is that inflation and inflation expectations move even higher, but central bankers have the policy tools at their disposal to rein in price pressures if necessary. Thus far, the markets appear to accept this thesis, with limited signs of concern about the central bank’s policy being too lax or the potential for long-term inflation to move materially higher.
A return to a moderately higher trend inflation rate of 2.0–2.5% (measured by the CPI) wouldn’t be surprising or problematic.
To evaluate the long-term potential for inflation, one has to look beyond the cyclical factors currently driving the surge in prices. The primary long-term forces that have helped to create and maintain the low-inflation world of the past few decades still exist and should reemerge as major drivers influencing relative price stability as the impact of other temporary factors fade. Demographics in the United States are far from inflationary, as the population ages and the birth rate slows. Technological advancement, which not only drives productivity gains but is also a major disinflationary force, certainly isn’t slowing down. Both should remain key disinflationary drivers over the longer term.
There are risks, however. A third major disinflationary force over the past several decades was globalization and the resulting opening of a massive pool of inexpensive labor that benefited American consumers through the availability of low-cost imported consumer goods. But the effects of globalization aren’t universally positive, and populist forces in the aftermath of the global financial crisis brought those challenges into focus and pushed back against free trade. The rise of nationalistic and anti-globalist sentiments and policies in recent years, along with growing geopolitical frictions, raise questions about the directionality of the outlook for global trade, economic cooperation, and economic and tax policies in the coming years.
Certainly, there are very good reasons to expect that the existing ties that have been created over decades are deeply embedded and — while imperfect — are more beneficial than not. Even so, this will be an area to watch for material policy developments over time.
The primary long-term forces that have helped to create and maintain the low-inflation world of the past few decades still exist and should reemerge as major drivers influencing relative price stability as the impact of other temporary factors fade.
The bottom line
A year ago, the economy was trying to find its footing after its steepest quarterly decline ever. The recovery that started last summer was also historically noteworthy, and the subsequent infusions of cash into households and businesses provided even more fuel for consumer spending. Continued progress in the fight against COVID-19, the lifting of restrictions across the country, and a stockpile of cash should all contribute to robust consumption growth in the coming quarters.
Righting the ship on the supply side to meet that growing demand, rebuild inventories, and repairing global supply chains will take longer but will ultimately happen. In time, the current impediments to hiring will fade and sidelined Americans will return to work. Supply chain bottlenecks in transportation and production will be relieved. Production capacity will increase. The economy will fully reopen. Demand will normalize. Market forces will cause the current imbalances to be addressed. As these occur, we expect inflation pressures will also ease, although a moderate increase in trend inflation over the exceptionally low level of the past decade wouldn’t be a surprise, particularly given the Fed’s stated policy goal of attempting to do exactly that.
Of course, the risk of a policy error exists that could allow higher inflation to establish an unwanted foothold and remain elevated for an extended period, but that’s not the baseline view. Market-based expectations for long-term inflation have edged higher, but remain contained, suggesting that most still believe that the surge in prices is temporary and will fade as near-term supply demand imbalances are relieved.
In this piece, we have only touched the surface of the many considerations and issues that may influence the path forward and what it means for investors. We will continue to closely monitor developments and provide additional comments and updates as conditions evolve. If you would like to discuss this further, please reach out to your advisory team.
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