October 29, 2021

The Case For and Against Inflation

By Michael McKeown, CFA, CPA - Chief Investment Officer

The Case For and Against Inflation

Ever since Federal Reserve officials described inflation as ‘transitory,’ the debate has swirled: Is the economy going to see runaway inflation due to massive stimulus, or will it be a short-lived event? (After all, the economy only reopens once.)

The case for ongoing inflation has several votes in its favor.

Today, businesses cite attracting and retaining people as their top challenge due to a low supply of labor. Wages are finally growing nationally, approaching 4% year-over-year growth according to the Atlanta Fed Wage Tracker. As the economic cycle continues, this wage growth may continue.

Atlanta Fed Wage Tracker

Supply chain issues are challenging businesses and consumers alike. Delivery times for items like furniture seem to keep moving further out. Ships delivering goods in ports have to wait weeks to unload. Components that go into electronic devices and cars are difficult to come by, pushing end-product prices higher.

Since we see these issues every day in the news and our own lives, it seems inevitable that inflation is here to stay.

There are, however, factors pushing against inflation.

The latest data for the consumer price index (CPI) rose 5% year-over-year. About 1.5% of this was due to an increase in energy prices — particularly oil, which rose from about $40 per barrel a year ago to $85. It is hard to fathom oil doubling again over the next year. The pace of increases seems likely to slow as producers respond to higher prices with a greater supply of oil.

Many of the ‘reopening’ categories, like airfare prices, rental car rates, and food away from home, rose rapidly in the last year. This contributed another 1% to the 5% increase. This also seems unlikely to keep pace with the torrid rate of the past year as things return to normal. The rest of the increase in CPI was due to ‘non-reopening’ categories rising 2.5%, which is average.

The trillion-dollar government stimulus plans grab headlines, but the spending would be spread over the next 10 years. Goldman Sachs expects the government fiscal deficit to increase only 0.5% in 2022. This would have less of an inflationary impact than the news would suggest.

Finally, the bond market is not sounding alarm bells. If anything, the inflation premium is falling. While it is a simple metric, the yield curve spread between the 5-year Treasury and 10-year Treasury has fallen steadily since March. This is a sign that those with money on the line see inflation and growth rates falling rather than increasing as policy becomes tighter (due to tapering of asset purchases and increases in short-end interest rates).

Yield Spread - 5s/10s

There are plenty of narratives and data to back up either take on inflation. The next few months will offer a much better idea of which side is right.

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