Inflation: Transitory or persistent?
Over the past 18 months, Congress and the Federal Reserve Board have used a variety of methods to stimulate and inject liquidity into the economy following the first signs of COVID-19. Those actions included benefit payments to individuals (including enhanced unemployment insurance), loans and grants to businesses, cuts in interest rates, and open-market bond buying by the fed. These fiscal and monetary steps were necessary to stave off a prolonged recession.
Given the significant longer-term deficit spending approved by Congress, history would expect the fed to hike short-term interest rates to cool off the growth of the economy and stave off inflation. Interestingly, the deficit spending has not yet had a negative impact on inflation, which for years stayed under the fed’s 2 percent to 3 percent target.
However, the unprecedented amount of stimulus and liquidity since early 2020 appears to be putting the U.S. economy on a more typical growth and inflationary trajectory. Real GDP rose approximately 6.5 percent in the first half of 2021, and the Consumer Price Index (a main benchmark of inflation) was rising at 5 percent annual rates in the second quarter, the highest level since September of 2008.
This leads to the question, is inflation a shorter or longer-term issue? The Federal Reserve continues to believe the inflation is “transitory.” By maintaining short-term interest rates near zero, the fed has signaled it is more concerned about the state of the economy than the risk of inflation. The bond market is also signaling that inflationary pressures are short-term given the fact that 10-year Treasury bonds are yielding just 1.5 percent. Interest rates are closely tied to inflation, so the recent jump in consumer prices does not seem to concern bond investors.
In addition, the recent increase in U.S. consumer spending, which is helping push up prices, can largely be attributed to COVID unemployment benefits that first were saved in 2020 and now are being spent. Those benefits are being phased out. We note, too, that supply-chain imbalances across the world are causing shipping costs to skyrocket, and that while it was naive to think supply-chains could return to normal overnight once vaccines were approved, it may also be naive to think that these same broken chains won’t be fixed.
On the flip side, there are rationales for longer-term inflation. Historically, when inflation starts to surge, it adds fuel to future inflation by creating unwanted consequences: A tight labor market forces employers to pay significantly higher wages; and the supply of goods doesn’t keep up with higher demand.
In the case of labor, shortages have been experienced in lower-paying service jobs such as retail, restaurants and hospitality. Part of the reason it has been difficult to fill these positions has been many of these individuals have earned more income from federal and state unemployment benefits than they earned working. Benefits have since been reduced, but employers still feel the need to permanently raise wage levels above pre-pandemic levels to lure workers back.
Prices aren’t just the result of supply and demand forces; they are also an indication of what prices are expected to be in the future. For example, lumber prices had risen close to 550 percent over a 13-month period ending in May as housing demand became extremely strong and lumber scarce. While prices have backed off since May, it is unlikely the spike in prices of lumber and other goods will revert to pre-pandemic levels anytime soon, if ever.
It also remains to be seen if the unequalled deficit spending of the past 18 months will significantly reduce the value of the U.S. dollar against our trading partners’ currencies, an event that would cause the cost of imported goods to rise and help create ongoing inflationary pressures.
It is important to note the Federal Reserve is edging closer to removing some of the monetary stimulus (by paring back its bond purchases) which should modestly cool inflation. Nevertheless, in such times, construct an “all weather” portfolio that performs well over long-term market cycles to keep from focusing too much on shorter-term fluctuations in economic indicators.
Gary Dyer is senior portfolio manager at The Sanibel Captiva Trust Company.