Inflation - Transitory or Here-to-Stay?
Forty years is a long time. This is more than one generation. It is odd to realize that a very fundamental economic concept is merely a theoretical one for anyone born in the last forty years in the U.S. Yes, we are talking of inflation. The U.S. has seen very tepid inflation in the last forty years. An entire generation exists who has little experience or understanding of the impact high inflation can have on living standards, savings, and investments; much less on how to navigate this environment. With the inflation drum rolls beating louder, is this going to change soon?
There are various measures of inflation. Most commonly used is the Consumer Price Index for All Urban Consumers, which increased 5.0 percent from May 2020 to May 2021. Prices for food went up by 2.2 percent, while prices for energy increased 28.5 percent. Prices for all items less food and energy rose 3.8 percent for the year ended May 2021. This is the largest 12-month increase since 1992. Even without the official data, we are experiencing a sticker shock on many products. Is there anyone whose job it is to try to keep a lid on inflation?
In the U.S., Congress has given the Fed a mandate to aim for maximum employment and price stability. The Fed defines price stability as an annual inflation rate of 2 percent on average. So, what does the Fed has to say about the recent jump in inflation? Until its last meeting, the Fed was not concerned about it. However, it did change its guidance on interest rates in the last meeting. But even then, it is not overly concerned that the current inflation is here to stay. It believes that what we are seeing is transitory. Fed expects inflation to be 3.4 percent in 2021, 2.1 percent in 2022, and 2.2 percent in 2023.
Before debating on Fed’s outlook, let us look at what is causing the current jump in prices. A broken supply-chain and a tight labor market are the two main culprits of this recent jump in inflation. And both these factors are byproduct of the pandemic. The sudden reopening of the economy, along with huge government support, created enormous increases in demand. This demand happened at the time when the global supply chain is still broken due to pandemic. Low labor participation is due to lack of childcare and concerns of being exposed to the virus. This higher demand than available supply, both for labor and products, is creating an inflationary environment.
A not so obvious factor that influences inflation is what is called “inflation expectation”. Think of it like this - inflation expectations are what households and businesses believe the rate of inflation will be over time. If a company believes that its costs will rise in future, it will need to find ways to cover these higher expenses. And one of the ways to solve this would be to raise prices. If the workers believe that their cost of living is going to go up in future, they demand higher wages. Businesses pay to keep the workers, but they raise the prices of their products and services to compensate. The big risk with inflation expectations is that it can become embedded in consumer behavior and business decisions. And this can become a self-fulfilling prophesy.
The Fed believes that the current inflation acceleration will stay high for a while but will moderate over the next year. Reasoning behind this is that businesses will have more time to adjust output, and the government payments to households and businesses will go away. With more vaccination globally, not only would the supply-chain will recover, but the labor participation will increase too. This will lead supply and demand to be back in balance.
We are not at a point where we have clear visibility into which way future inflation will go. But it is time to watch both the inflation measures, and the inflation expectations. A more sustained rise would affect not only the markets, but our lifestyles and investments as well.
Lavina Nagar, CFP(R) is the president and founder of Maya Advisors, Inc., a financial planning and investment firm in Palo Alto, California.