Ghosts of Inflation Past
Is it just me or has inflation become the latest media and/or pundit fixation du jour? From all the recent pontifications one would almost forget we are still coming out the other side of a pandemic that ravaged the U.S. economy and precipitated an abrupt recession. According to the National Bureau of Economic Research, the unemployment rate shot to 14.7% in April 2020, the highest recorded monthly rate. The resulting decrease in personal consumption—combined with a sharp decrease in business investment—caused demand to fall quicker than a flopping NBA player attempting to draw a foul.
Consequently, the U.S. economy suffered a second-quarter annualized decline in gross domestic product (GDP) of 31.4%, the highest recorded single-quarter decline in real GDP. Unimaginable economic straits in February 2020.
Economics 101 teaches us the fundamental supply-demand relationship, particularly how the two curves converge to create an equilibrium price. Any major shift in just one of those curves will, in turn, cause the equilibrium price to shift. Specifically, the dramatic shift in demand, spurred by the pandemic, caused the demand curve to shift left (inward), thereby leading to a precipitous drop in the equilibrium price level. Although eventual factory shutdowns would also lead to a shift of the supply curve, it was not commensurate with the shift of the demand curve which, theoretically, would have resulted in a stable equilibrium price level.
In other words, the pandemic caused a severe pullback in demand, which depressed prices or resulted in deflation. And since inflation is annualized over a rolling twelve-month period, this would become our “base” level against which future inflation would be measured.
As one would expect, the reverse is also true regarding the supply-demand relationship and the equilibrium price level. A sudden increase in demand in the absence of a corresponding increase in supply will lead to a sharp increase in the equilibrium price level. A decrease in supply would exacerbate such a price increase. Unfortunately, this is precisely what occurred. Various supply- chain disruptions converged—from a shortage of semiconductors to congestion at the nation’s ports to unused business capacity as a result of labor shortages—to increase the price level to the ridiculous levels we have seen lately.
The recent increase in the price level appears even more dramatic when we compare it to the aforementioned “base” level, a level severely distorted and anomal-ized by a historically devastating pandemic. All this translates into what is commonly understood in statistical or economic circles as the “base effect”. To the laymen, it simply means our prices began from such a depressed, basement level that any subsequent increase will appear dramatic or extreme. To the initiated such a seemingly dramatic increase in the price level, from where we started, comes as no surprise. In fact, it was expected.
On what the markets are saying: “We think there’s inflation in the near-term, but eventually it’s going to ease and go back to the Fed’s 2% target—maybe be a little above, but it will certainly not remain elevated.” (Kathy Bostjancic, chief U.S. financial economist at Oxford Economics)
The Fed has regarded the factors converging to influence the rise in the price level as largely “transitory”. That is, no one reasonably expects the challenges surrounding labor shortages, supply-chain disruptions, etc. to continue indefinitely. Things have a way of reverting back to the “mean”. The same goes for the demand side of the equation. With an anticipated pull back in the various forms of COVID-induced stimulus from the federal government, coupled with dwindling savings, demand is expected to taper off a bit as well. These factors will combine to bring the price level, or inflation, back down to what is considered normal long-term levels in the 2.0- 2.5% range (whether one uses the Fed’s preferred inflation gauge, the personal consumption expenditures (PCE)index, or consumer price index (CPI)).
Most outside of the news media or Wall Street punditry are in complete agreement on this and have never feigned surprise over the temporary rise in prices.
A recent article in the Wall Street Journal has even suggested a number of inflation measures are beginning to ease. According to the University of Michigan’s consumer surveys, the median expectation of inflation is down, with one-year expectations sitting at 4.8%, down from today’s 5.4%. The longer-term outlook is even better with the five-to-ten-year expectation coming in at 2.9%.
Business inflation expectations were rosier, as measured by the Federal Reserve Bank of Atlanta’s monthly survey of 300 businesses, which measures businesses’ expectations of their own costs (that does not always translate to higher selling prices). One year from now companies expected 2.8% inflation, which is down from 3% in June.
Newsflash to all the inflation fear-mongers with self-serving agendas: this is not 1974 or 1979- 80’s redux; we will not be experiencing average double-digit, or near-double-digit, inflation.
The moral of the story for investors, average and otherwise: I would stand pat…that is, assuming your investment portfolio allocation mix was appropriate before the recent bout of inflation. The worst thing you can do is compromise your portfolio by playing price-level musical chairs, jumping from this allocation/stock to that as the music of inflation stops and starts. While the past often repeats itself and there is much to learn from it, such reiterations are rarely exact, as their causes—and their respective weights—may vary.
As much as I love Matthew McConaughey, Ghosts of Girlfriends Past was widely considered to have flopped at the box office. So, too, will the latest round of inflation-hawking by Wall Street pundits.
I.D. Amandah