Inflation Worries: Will the Tide Rise Higher?

In April 2021, consumer prices rose sharply, driving the rate of inflation to the highest level since 2008, which sparked concern among investors though the Federal Reserve says the rise is temporary and will soon ebb.

In contrast, the current rate of inflation has jumped to 4.2% in April. Despite the fact that at this time a year ago, the economy was hit with the worst of the Covid pandemic and inflation was unusually low which makes for a difficult comparison, economists believe inflation, which has remained at unusually low levels over most of the last decade, is showing some growth as the U.S. economy reopens quickly with trillions in federal stimulus spending layered on top of the Fed’s near-zero interest rates, plus crowds of newly vaccinated shoppers ready to spend.

Adding to the stress on the economy is the struggle of businesses dealing with supply shortages, which raises the cost of many goods and services. For example, pandemic-related bottlenecks affecting the global supply of computer chips are holding up production of new cars. As consumers rush back to restaurants and vacation spots, prices at these venues rise due to increased demand.

Senior Fed officials such as Lael Brainard recommend patience, contending inflation will subside once the pandemic fades in 2022, with the workforce returned and the global economy likely recover.

“Remaining patient through the transitory surge [in inflation] associated with reopening will help ensure that the underlying economic momentum that will be needed to reach our goals … is not curtailed by a premature tightening of financial conditions,” Brainard said at a virtual event hosted by the Society for Advancing Business Editing and Writing on May 11, 2021, hosted by the Society for Advancing Business Editing and Writing. “To the extent that supply-chain congestion and other reopening frictions are transitory, they are unlikely to generate persistently higher inflation on their own.”

She noted that “a persistent material increase in inflation would require not just that wages or prices increase for a period after reopening, but also a broad expectation that they will continue to increase at a persistently higher pace.”

The question is whether the coming wave of inflation will be a modest, easily managed wave or a dramatic flood that will roil markets, kneecap savers, and cause the Fed to rapidly hike rates, imperiling the recovery.

What Is Inflation?

Inflation is the rate of increase in prices over a period of time; it is typically measured broadly, such as looking at the overall increase in prices or the increase in the cost of living in a country.

In other words, inflation is the decline in a currency’s purchasing power. The price increase in goods and services over time can reflect a quantitative estimate of the currency’s rate of declining purchasing power. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.

As a currency loses value, prices rise, and fewer goods and services can be bought. This loss of purchasing power impacts the general cost of living for the common public, which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.

To combat this, a country’s appropriate monetary authority, such as the Federal Reserve, then takes the necessary measures to manage the supply of money and credit to keep inflation within permissible limits and keep the economy running smoothly.

An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy.

Money supply can be increased by the monetary authorities by printing more money, legally reducing the value of the legal tender currency, or—most commonly—loaning new money as reserve account credits by purchasing government bonds from banks on the secondary market. In all such cases of increasing the money supply, the money loses its purchasing power.

What’s Happening Now?

In the first quarter of 2021, the federal government approved nearly $3 trillion in stimulus spending. That expense came in addition to the $2.2 trillion passed at the beginning of the pandemic.

Congress gives the Federal Reserve a dual mandate: Foster maximum employment and maintain price stability. The Fed has interpreted maintaining price stability as keeping inflation growing at about 2% a year over the long term, seeing a little bit of inflation as a good thing. Many investors agree, favoring a bit of pricing power for successful companies, since it is easier to increase profits with a bit of inflation in the air. When inflation runs high, workers are empowered to ask for bigger raises to keep up with the cost of living, and debtholders get a break on their obligations as their borrowed money becomes comparatively less valuable.

But too much inflation is a bad thing; the central banks must increase interest rates and slow the economy to keep price increases from getting out of control. Too much inflation can lead to hyperinflation, which strips the shelves of products, renders money worthless, and does grave damage to normal commerce. Hyperinflation makes life a little more complicated for savers and retirees on a fixed income since it erodes the purchasing power of every dollar.

The problem is that for much of the past two decades, the Fed has not lived up to its mandate. Using the Fed’s preferred gauge of inflation, core Personal Consumption Expenditures (PCE), which tracks price changes over time without volatile energy and food costs, inflation has remained stubbornly below the Fed’s 2% annual target since the Great Recession, except for a brief stretch in early 2012 and much of 2018. But even in those periods, inflation never rose above 2.12%.

While inflation is expected to jump to 2.4% this year, above the central bank’s 2% target, officials such as Brainard and Fed chair Jerome Powell view this as a temporary surge that will not change the agency’s pledge to keep its benchmark overnight interest rate near zero as part of an effort to ensure the economic wounds from the pandemic are fully healed.

Should President Biden get his $2.3 trillion infrastructure bill through Congress, even more money will flow into the economy. The Fed may even have to update its inflation projections again.

The Fed’s official stance is that it will tolerate inflation rising “moderately” above its 2% target, but Powell reassured the markets that if prices look like they may run away, policymakers “will use our tools to guide inflation and expectations back down to 2%.”

For now, the Fed is not overly concerned about the price increases, viewing them as not the type of inflation that could spiral out of control. Powell said in May that officials expected to see short-lived price spikes as the economy reopened and consumers started spending again.

Still, market-watchers are unsure about the component of inflation that may not be temporary: the rebound in spending and demand in the face of unprecedented stimulus from the government and the Fed.

Economists and policymakers are also carefully tracking the shortages as they hunt for signs of inflation, and companies are increasingly worried that the price spikes may not be temporary. The Fed’s latest Beige Book survey found that businesses were citing “Covid-related disruptions in production and supply chain logistics” as reasons for shortages and price spikes of commodities such as “agricultural products, building materials, cleaning products, and microchips.”

Commodity prices, a leading indicator of inflation, continue to rip higher. West Texas Intermediate (WTI) crude oil prices are up more than 17% over the past quarter and have soared nearly 12% in the last month. Some commodities such as copper and corn have jumped to their highest levels in almost a decade as major economies rebound from the pandemic.

Commodity shortages are rippling across the U.S. economy as growing demand for housing, cars, electronics, and other goods runs up against supply-chain congestion and high tariffs left over from the Trump administration.

Conclusion

The Federal Reserve believes that the current price increases are “transitory” and will slow down and stop as the economy returns to normal. CEOs and many investors do not believe the price increases are transitory. If you find yourself fearing inflation, now’s a good time to consult your financial adviser.