The latest question to divide the financial world is the following: Is inflation finally returning to the United States? Investors last had to navigate inflation in the 1980s when it was acute, but inflation has not been a problem for decades. Is it about to heat up again?
As in any good debate, we need to define the key terms and issues. What is inflation? Inflation is a broad-based decline in the purchasing power of a currency. In other words, it is a broad-based increase in the price of goods and services. Why are we worrying about it now? Because it is widely believed that inflation is caused when too much money chases too few goods. Since the onset of COVID-19, an unprecedented amount of money (also known as liquidity) has been provided by the Federal Reserve and the Federal Government to consumers, corporations, and state and local governments to help keep the economy running. Will this enormous amount of money spark inflation?
The “Yes Inflation Camp” posits that the no-expense-spared response to the pandemic has put us on a crash course for rising prices, as consumers release pent-up demand. The “No Inflation Camp” believes that the pandemic has not truly altered underlying deflationary dynamics that have been in place since the Great Recession, and that any inflation will prove temporary. Let’s explore these positions further.
Yes Inflation Camp
The Yes Inflation Camp believes that the wave of stimulus money injected by central banks and governments to fight the pandemic will push prices higher. The COVID-19 stimulus is different than past stimulus efforts because much of the money is flowing directly into the pockets of consumers and companies. Households are consequently flush with cash. Having had fewer places to spend money early in the pandemic pushed savings rates up and stimulus checks provided consumers with lots of money that they are itching to spend.
Supply chain problems are pushing prices of certain goods up. As an example, oil and gasoline prices are higher, due not only to increased driving rates, but also conflict in the middle east and pipeline closures. An increase in energy prices has been a catalyst for past rises in consumer price inflation.
A reopening economy has resulted in an improving job market and demand for qualified workers is outstripping the available supply. Many businesses are having to entice workers back with wage increases and sign-on bonuses. At the same time, asset prices have risen, increasing the cost of everything from houses and equities to cryptocurrency. Inflation expectations are also moving higher. As consumers and businesses expect inflation, their buying habits change which can lead to even more inflation.
The historical defense mechanism against inflation has been the Federal Reserve. The Fed, however, has committed to let inflation “run hot,” or over their normal target rate of 2% in the near term. Proponents of the Yes Inflation Camp believe that this allowance for transitory inflation could spill into more sustained price level increases.
No Inflation Camp
The No Inflation Cohort believes there are several cyclical and structural factors that will prevent sustained inflation. It is important to note that many in this camp grant that there may be some near-term and transitory inflation. You cannot just flip a switch and expect the economy to move from quarantine to full employment without a little noise.
To begin, this group asserts that if unemployment remains at 6% or higher, there is more labor capacity available. An economy that is not using all its available labor resources can typically grow without triggering inflation (the unemployment rate dropped down to below 5% in 2019 and did not trigger inflation). The unemployment rate is 6.1%, as of the end of April. Moreover, if households remain cautious about health and employment prospects, the increased savings that consumers have accumulated may remain unspent.
The most important member of the No Inflation Camp is the Federal Reserve, which is currently not in a hurry to take away the proverbial punchbowl from the economic recovery party. The Fed’s members continue to insist that this current spike in inflation is transitory. Some members have gone as far as to suggest that the recent rise in inflation expectations is exactly what the Fed intended. They believe that the price rises will subside as supply catches up, reopening is completed, and stimulus checks are spent.
From a structural perspective, globalization, slowing population growth and an aging of the population have kept price pressures low, leading to low inflation over the last three decades. And despite some recent increases in consumer prices, the evidence that the price increases are widespread is currently inconclusive.
It will take time for all of this to play out, which will give each camp economic data points to feed the argument. The inflation outlook is uncertain because the Federal Reserve and the Federal Government have never unleashed this quantity and manner of stimulus and we have not had to reopen the modern economy from a global pandemic before.
Becker Capital Management is carefully tracking the inflation data. We have increasingly positioned our portfolios to endure higher inflation rates in the near-term. Moreover, we continue to examine new opportunities considering their potential behavior in an environment that includes higher inflation.