Inflation and All That Jazz

Friday Reflection | October 15, 2021

Sentiment often drives stock markets just as much as the fundamentals of revenue, growth rates, and profitability. Witness the stock market rise by nearly 2% yesterday after banks reported increased earnings and new jobless claims came in lower than expected. Banks may not be an accurate bellwether for other industries, and pandemic-lowered workforce participation rates dilute the jobless claims data – and yet investors’ optimism jumps up in response to the short-term data.

Interest rates and inflation are subject to similar shifting and qualitative forces. Beyond actual inflation, the Federal Reserve is concerned about the expectation of inflation because it can create similar economic reactions. Over the past six months, financial news sources have waxed prolific about whether pricing increases due to pandemic-induced shortages will lead to sustained inflation. In other words, can we consider it to be temporary but real inflation? Or should we expect it to be an ongoing situation that warrants pulling back from various spending and investment decisions?

In a way, the answer doesn’t matter. We have real price increases and product shortages that are impacting consumers today. Several of the constituents of the Consumer Price Index (CPI) such as rent, energy, and food are expenses that must be met in the short term. When prices go up, it crimps other spending and effectively creates a lower standard of living. With the cost of delivering goods and services going up, and demand leveling out after a big jump in the spring, many businesses may be hard-pressed to pass on significant price increases. That can be bad news for profit margins but is also a release valve for inflationary pressures.

From the perspective of the older consumer, the higher CPI also has an upside. This week the annual social security inflation adjustment was announced at a whopping 5.9%, the largest increase in 40 years.¹ That increase will provide some 70 million recipients with a boost in income that should also help boost consumer spending, particularly if the current inflation is indeed temporary. 

Led by headlines highlighting energy price increases, it is easy to make the mental jump to the “runaway” inflation of the 1970s. Beginning in 1973, inflation jumped over 5% and didn’t come down until nearly a decade later. During that period, inflation averaged 8.7%. In contrast, average inflation for the 12 years prior to 2021 was a mere 1.4%.² We hold the view that today’s higher prices will come back down in the course of the next 6-18 months as the pandemic distortions are gradually worked out. We aren’t in for the same experience that we had fifty years ago.

While it is true that areas of spending that were anemic a year ago – travel and transportation in particular – have recovered significantly, we don’t think there is cause to extrapolate the short term reality into a longer term disaster. A year ago, the topic of concern was the Fed’s inability to prompt inflation, falling short of their 2% target.³ Now, with dramatic short-term supply-chain disruptions affecting the movement of global goods, and public health issues limiting labor force participation and pushing up wages in certain industries, the worry has flipped. Yet our current economy remains more fully oriented towards deflation than inflation. Unlike fifty years ago, the pace of technological innovations, the overall low level of workforce participation, and the deepening global integration all have deflationary impacts. 

Technical innovation means more money spent on machines and less on labor, which translates to higher economic productivity per worker. At the same time, labor force participation in the US remains significantly lower than pre-pandemic. Long-term sustained inflation requires economic growth and full employment; that can come only as employment recovers its equilibrium. Without that, persistent inflation will be hard to sustain.

Beyond the domestic economy, globalization is fundamentally different today than in the 1970s. One source of the low inflation we’ve had in recent decades is the way in which Western technology has combined with cheap Asian labor costs to create a glut of inexpensive goods and services. Simply because those goods are delayed in containers parked off the coast of Los Angeles doesn’t change the fact that the productive capacity we have globally remains more robust than current demand.⁴

At an individual level, each of us has a unique set of circumstances that may or may not mean we are impacted by today’s price increases for natural gas or used cars or furniture. Spending patterns will keep shifting as we move through the pandemic, with opportunities large and small becoming available again. Being able to change course quickly, and keeping our expectations for the future flexible will serve us well as both the innovations and limitations of the future come to pass – whether or not that includes inflation.

Resources

¹ Jeanna Smialek, “Consumer Prices Jump Again, Presenting a Dilemma for Washington,” New York Times, October 13, 2021.

² “Historical Inflation Rates 1914-2021,” US Inflation Calculator.

³ Gary Shilling, “Deflationary Trends Are Growing More Powerful,” Bloomberg Opinion, October 13, 2020.

⁴ Ibid.