Will Inflation Be Transitory?

Inflation has been a popular topic of ongoing discussion among investors and the financial world. Is it transitory as the Fed and IMF anticipate? Below, we will look at some of the underlying factors driving the current inflation rate and the conversations that surround it.

The pandemic was an unprecedented global event that crippled global supply chains. The ensuing public health quarantines and loss of income contributed to an eradication or significant reduction of demand in most industries while causing some temporary hoarding in others. Now, as economies continue to reopen and restrictions are lifted, we are seeing a rapid and significant increase in pent-up demand. Supply chains cannot recover or scale fast enough. Lastly, geopolitical policies on international trade continue to add further constraints to the existing import-export burdens experienced between manufacturers and consumers.

Supply chain economics in distress
A well-oiled, global economy is emerging from an unprecedented disruption.  Entire industries essentially shut down as did most in-person interactions. Unemployment levels rose critically fast and supply chain economics broke down. Countries as well as international trade unofficially closed. A lack of labor, materials, and distribution channels led to global shortages in everything from computer components to basic necessities such as toilet paper and bottled water. The basic economic principles of supply and demand faced a rapid and global emergency. The brunt of which was burdened by the supply side.

Rising Prices: Demand pull and supply push
Capitalism aside, prices rise for two main reasons. Too much demand or not enough supply. The pandemic combined with federal stimulus and ongoing economic recovery has created both scenarios. Pent-up demand and critically disrupted production have driven up prices throughout supply chains. Has this led to a confident economy poised for further inflation or are we now in a transitory period due to a pandemic-driven drought? Both? How long should a transition last before it is not transitory any longer?

Demand Pull
When demand exceeds supply, prices are “pulled” higher based on the surge in demand. This is “demand pull”. As the U.S. economy began opening, previously isolated consumers tempered by the pandemic emerged in force. An economy jolted awake by economic stimulus, a significant drop in unemployment, and just the release of pent-up demand is more than a crippled supply chain economy can bear. It is also worth noting that each country and individual U.S. states were recovering at different paces, contributing to this exponential wave of demand.

Since we are talking about a recovering economy, it is worth acknowledging that there is a lot of media coverage surrounding key industries’ inability to fill positions. But, this could be adding to potentially misleading levels of unemployment concerns. There are jobs available. They just cannot fill the positions. This is especially true in the hospitality and service industries. While it is a major occupational and economic concern, the fact is unemployment levels have dropped significantly from their pandemic-driven peak. The national unemployment rate for June 2021 is hovering at 5.9%. This number is still higher than February 2020 pre-pandemic levels, but unemployment is at its lowest since Q3 2014 and is significantly better than the 14.7% peak of April 2020 when the pandemic’s end was nowhere in sight.

Supply Push
When events constrain supply, prices can be “pushed” higher based on the existing demand for that product that supply can no longer meet. This is “supply push”. As discussed above, the effects of the pandemic impacted global supply chains from top to bottom. What made this unprecedented was the fact it was global and affected almost every industry to some extent. Considering supply chains span regions, countries, and continents, the lack of access to labor, materials, and distribution channels cascaded up and across the supply chain and the globe.

Now as the world emerges from the pandemic increasingly faster, some regions and industries lag others in their recovery. It takes time to recover, replace, or retrain staff. There are still gaps in production, inventory, and the general ability to bring goods and services to consumers. Supply just cannot recover from this unprecedented disruption as quickly as demand wants. The fact that supply is trying to catch pent-up demand and not just meet pre-pandemic levels.

Inflation loves an excess of cash and spending
Whether it is a fear of rising inflation, actual rising prices, higher wages, or something else, inflation always feeds off more cash changing hands. So, the pandemic-induced scenarios above of pent-up demand and supply constraints are great examples of how current pricing is contributing to inflation.

When it comes to pent-up demand and spending, rising inflation rates only compound the problem because it increases the desire to spend. For example, inflation means the same $100 in your pocket today will not be worth $100 next month. When the inflation rate rises, the rate in which the value of that $100 erodes increases, and (most importantly) the effects compound over time. It only makes sense to spend or invest it if inflation is on the rise. In turn, consumers can fuel further inflation through their own desire to make purchases and “beat” future rate increases.

But if we look at cash, on the surface, there is a significant amount of financial liquidity compared to a year ago. The M1 money stock, which is a measure of money supply and includes the most liquid forms of money such as cash and checking accounts, grew from $4.8T in April 2020 to $18.9T in April of this year! The M2 money stock is surging too. The M2 is a calculation of money supply that includes the M1 elements along with semi-liquid “near money” such as savings deposits, money market securities, and mutual funds.

The M1 and M2 scenario above seems to contradict the point on spending. For the sake of this article, it can be argued that the past year saw a lot of money move from less liquid accounts into M1, many people’s demand for cash increased during a period of financial stress, and institutions were suddenly required to hold reserves against checkable (M1) deposits. However, it’s worth noting that if enough of this cash makes its way into the marketplace instead of investments, it would create further long-term pressure on inflation.

FRED M1 Money Stock

Inflation is part of our economy
It is important to understand that inflation has been present nearly every year for the past century. The Fed plans for around 2% a year. While you may hear a lot about inflation being an “invisible tax”, it isn’t untrue. However, inflation is a good thing in moderation. While lower prices sound great, it could be a sign of a struggling economy and low wages. In other words, deflation. The goal would be a growing economy with stable inflation that strikes a balance between employment, wages, and consumer pricing.

Measurements and more measurements
We should start out by mentioning that there are several indexes used to monitor economies. Each measures a different perspective on its performance and health. Wholesale Price Index (WPI), Producer Price Index (PPI), Personal Consumption Expenditure (PCE), and Consumer Price Index (CPI) are examples. For the sake of this article, we will be referencing PCE and PCI. Here is a general explanation of each.

  • Consumer Price Index (CPI)Calculated by the Bureau of Labor Statistics (BLS), CPI examines the average change in price “urban” consumers pay for a “basket” of goods and services. These predetermined categories of retail goods and services are meant to represent primary consumer needs and are weighted by their share of total household expenses. CPI figures are mainly gathered from consumers.
  • Personal Consumption Expenditure (PCE) Calculated by the Bureau of Economic Analysis (BEA), PCE examines the change in prices for goods and services sold to all U.S. households. In general, how much are consumers spending. It includes a broader set of weighted goods and services than CPI and is not limited to “urban” households like CPI. PCE figures are mainly calculated from businesses and the marketplace. It can be argued that PCE more accurately reflects how consumers adjust their purchases in response to changes in price.

Inflation indicators can still mislead
On the surface, indexes are the Fed’s best indicators of inflation and both the PCE and CPI figures have risen sharply from March 2021 to June. Monthly annualized PCE growth was 17.7% and, during the same time period, the PCE price index (PCEI) and CPI-All Item growth averaged 4%. This surpasses the Fed’s benchmark rate of 2%.

But it is important to understand the story behind the data. For example, CPI can be more susceptible to rapid swings in pricing and can overestimate increases and decreases. This is especially true of Core CPI which includes energy and food prices. Some retail pricing categories, such as food and energy costs can fluctuate rapidly month-to-month due to a variety of factors. In addition, housing typically is weighted as the largest piece of the CPI pie. In turn, large surges in home pricing and values can have a large effect on CPI.

Transitionary inflation with prolonged pressure and risk
There are clear transitory factors heavily influencing inflation. Unless there is well-timed and appropriate intervention by the Fed, there are risks that the existing economic disruptions may become long-term and allow the inflation rate to get out of hand, derailing U.S. economic growth.

Personal Consumption Expenditure Index, PCEI