Inflation is back: Is it here to stay?
INSIGHT ARTICLE |
After over a decade of quiescence, recent economic data has stoked inflation fears. The closely watched consumer price index (CPI) recently posted its sharpest increase since 2008, while the producer price index (PPI), which measures prices paid to producers as opposed to prices at the consumer level, saw its largest year-over-year increase since the government started tracking the data in 2010.
This marks a significant reversal compared to the decade leading up to the pandemic, when global disinflation (and fears of insidious deflation) held sway, evidenced by below-potential gross domestic product (GDP) growth, herculean monetary policies, negative interest rates in Europe and Japan, and anemic wage gains. Even the United States is just barely crawling out of a situation of negative real 1 interest rates.
The key question for businesses and financial markets, as well as for financial plans and portfolio construction, is whether these very real signs of upward price pressure are cyclical (short term) or structural (long term). Structural inflation, by definition, requires a persistent trend of higher input costs (materials and/or labor) that creates a self-fulfilling expectations loop; anticipated cost increases spur consumer price increases, prompting higher wage demands that translate into higher input costs and so on. Are we seeing signs of structural inflation?
The current inflationary landscape (prices)
The most recent spike in reported numbers can be largely attributed to what are referred to as “base effects.” The COVID-induced shutdown in 2020 drove economic activity and prices sharply downward, so the rebound in prices is showing up in the data as sharp increases. Just as a plane (prices) tracking the path of the Grand Canyon (economy) plummets as it descends into the canyon, it must quickly ascend the other side as it exits just to get back to level ground.
Still, we have witnessed tangible and significant signs of price pressures that are not directly tied to a normalization of economic conditions. Disruptions caused by plant shutdowns, shipping interruptions (Suez Canal blockage, port congestion) and natural events (ice storms in Texas, fires out West) have rippled through the supply chain, creating shortages and pushing up prices for semiconductors, plastic, petrochemicals, steel, lumber and agricultural commodities. Consequently, a number of company executives announced price increases on recent earnings calls, citing higher input costs resulting from the aforementioned drivers. However, we see these drivers as largely temporary. For example, the biggest outlier in April was used car and truck prices. Not only was demand for used vehicles boosted by stimulus checks, excess cash saved amid the shutdown and favorable credit conditions, but the production of new vehicles has been impaired by semiconductor chip shortages (a key component). While increasing the supply of semiconductor chips will take time, it is unlikely to become a structural issue. In addition, when auto production ramps back up, the pace of used auto price increases—to the extent we have seen recently—is very unlikely to be sustained.
The current inflationary landscape (wages)
On the wage side, businesses have experienced hiring challenges due to lingering virus fears and competition from stopgap unemployment benefits. While there are clearly pockets of mismatch in job openings and available workers, upward wage pressure has not come through in broader measures, such as the Atlanta Fed’s Wage Growth Tracker (Figure 1). Some businesses have stepped up starting wages or instituted one-time bonuses in order to attract workers, but the number of available workers should improve and upward wage pressures should abate as unemployment benefits expire, vaccination counts expand, infection risks fade and schools continue to reopen.
More broadly, the reduced influence of collective bargaining and unionized labor, along with the end of enhanced unemployment benefits, are significant headwinds to sustained wage inflation. Increased digitization and automation, accelerated by the pandemic, may also lead to faster productivity growth, which should further contain labor costs.
What to watch
There are some differences today versus 18 to 24 months ago and compared to the period post-financial crisis that bear monitoring. One is the Fed’s new average inflation target framework. Under this approach, it will permit inflation to run above its 2% long-term target for an indeterminate length of time. This means the Fed will deliberately fall behind the curve as inflation picks up, raising the risk that policymakers lose control of inflation and are forced to take economically punitive measures to regain control.
Another concerns government stimulus. Government spending, hardly the picture of austerity before, is set to continue unabated under the new administration. The level of debt/GDP has risen to historically high levels amid multiple COVID-related stimulus bills that have injected trillions more dollars into the economy while pushing government debt further into record territory.
While seemingly ever-increasing debt levels must be reined in at some point, we do not view this as a near-term risk given the low interest rate environment, which has kept the cost to service that debt near historical lows (Figure 2).
Even if inflation pushes interest rates up over the next 12 to 24 months, we do not expect them to rise to the point that servicing the debt becomes untenable. Negative real rates, as well as fiscal spending initiatives that support long-term growth (if successful), can also be very effective at softening the burden of high debt levels. In addition, we believe these factors can help pull the economy out of the disinflationary funk we have experienced since the Financial Crisis without posing a significant risk of structural inflation.
What the market is telling us
Ultimately, we believe much of the alarming headline inflation data will prove to be transitory. Nonetheless, the economic ingredients are in place for price trends to reach escape velocity from the disinflationary conditions of the past decade. Structural headwinds to higher inflation appear balanced against the risks stemming largely from fiscal and monetary policy. Financial markets appear to agree. While inflation indicators have moved higher from depressed levels, they still suggest only slightly elevated intermediate-term expectations.
The market is currently forecasting average inflation of less than 2.5% over the next 10 years (Figure 3)—above the Fed’s target range but well below worrisome levels. Drilling down, near-term levels are forecast to run higher while the average of the latter half of the period is expected to run closer to 2.0%.
What the Fed is watching
It is also important to consider that the CPI, most often referenced in the media and a component in determining market-implied inflation forecasts, is not the Fed’s preferred inflation gauge; it instead more closely monitors the personal consumption expenditures (PCE) index. More specifically, it focuses on the core readings, which strip out the more volatile food and energy prices, both of which have played a significant role in the recent spike. The distinction between CPI and PCE is also important because, as Figure 4 illustrates, core PCE readings have come in lower than CPI by an average of 30 basis points (0.3%) over the past decade. Further, the data are trending in opposite directions. This disparity is largely due to the composition and calculation methodologies, which is beyond the scope of this paper; however, the takeaway is that CPI data could continue to run at levels sufficient to garner further headlines, but the Fed may remain patient.
Should inflation continue its recent upward trend, what could investors do to mitigate the negative impact it could have on their portfolios? In our view, many of the traditional go-to hedges are either binary (TIPS only beat Treasuries if inflation exceeds certain levels), speculative (gold, Bitcoin) or too focused (dedicated commodity investments protect against commodity inflation, but not against broad price increases). That is not to say these asset classes could not be appropriate; however, in most cases we suggest a longer-term and less heads-or-tails approach.
Dynamic fixed income strategies that focus on reducing interest rate risk (duration) while looking opportunistically for sources of additional yield may be appropriate. Broad real assets—including real estate, infrastructure and natural resources—can benefit from a general trend of higher prices, with less opportunity cost if inflation remains modest. Over the very long term, high quality global equities have tended to be one of the best inflation hedges, as businesses with pricing power can sustain revenue and profit growth.
Investors are understandably concerned about whether the recent bout of inflation will continue—or worse, accelerate. Our analysis suggests we may see further pressure on input costs over the next several months, which companies may continue to pass on to cash-flush consumers. Wages, too, may push higher over the next few months. However, we expect gains in both areas to moderate over the balance of the year, perhaps into early 2022. Allocations to broad real assets and dynamic fixed income strategies can better position portfolios to mitigate the potential erosion of purchasing power should above-average inflation persist for a longer period than we anticipate.
1 Inflation is higher than nominal interest rates.
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