How to Think About Inflation Today
By Michael McKeown, CFA, CPA - Chief Investment Officer
Home prices are surging. Prices of cars are through the roof. Bottlenecks in supply chains are pushing prices up across the board. Finding new employees is a commonly cited challenge for businesses across industries.
Expectations for short-term inflation just hit a 9-year high at 3.7%, though longer run expectations remain stable compared to the past.
Because inflation was so low last year, economists predict the next few months will have high inflation data points. These are due to “base effects” of the recession last year.
Yet price increases at this rate were not durable following recessions in the past. Core inflation measures took several years to bottom following the last four recessions. Note the red arrows in the chart below.
Economists have a nerdy definition of what inflation is. We can quibble with it. But the reason it matters is that’s what the Federal Reserve cares about. And the Fed’s Open Market Committee sets interest rates. Markets around the world care about interest rates because financial and real assets use interest rates as an input for pricing.
Economists care about the long-run trajectory of sustainable inflation.
Inflation today is considered transitory – meaning, the supply problems we are seeing across industries are a result of the recession and pandemic. These are not considered multi-year issues at this stage.
That means inflation expectations should come back down to earth.
What would sustainable inflation look like?
It would likely be a result of perpetual fiscal stimulus. That could come in the form of government fiscal spending or the flip side, much lower tax rates. Both forms would put more money in the private sector at the expense of the government sector running a deficit. More money chasing more goods and services.
At this stage, the fiscal stimulus programs are temporary. In addition, tax rates will not be going down any time soon.
Inflation is a hard concept to fully project. There are so many factors that affect it. And even then, it may not come to fruition.
Japan is the poster child for this. Since the late 1990s, Japan enacted programs to keep a lid on interest rates. It also ran large fiscal deficits. For years, economists predicted runaway inflation and interest rates. Yet, today Japan’s interest rates are around 0% and inflation is still tame.
The Japanese economy “paid for” this with a depreciating currency. While one may point this as a bug in the system, it may actually be a feature. Sustaining positive incomes, employment, and business growth at the expense of a slow decline in purchasing power may be more palatable than the alternative.
A depreciating currency forces investors that who want a satisfactory return to invest in equities, fixed income, or real estate. Thus investors are pushed further out on the risk spectrum. We are also seeing the extreme of this – highly volatile speculation in certain asset classes.
Inflation will be a topic du jour for the next several months. Yet there are so many factors to think about as to whether it represents a true, long-term shift. It will be important to watch how policy evolves.
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