The Return of Inflation: Have We Seen This Movie Before?

We last wrote about inflation in May 2021 in a piece titled “Inflation Worries: Will the Tide Riser Higher?” (https://bowenasset.com/inflation-worries-will-the-tide-rise-higher/) A year later, we have an answer to the question: both the inflation rate and the anxiety it causes have increased.

A Pew Research survey in April 2022 showed inflation as the dominant concern of most Americans, with 93% saying it’s a “very big” or “moderately big” problem.

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 other words, inflation is the decline in a currency’s purchasing power; the higher it is, the less you can buy with a set amount of money.

The Bureau of Labor Statistics uses the Consumer Price Index to track the rate of inflation. The CPI measures over time the average change of prices that you pay for a variety of goods and services, including items such as gas, food, and housing.

Built-in inflation is related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. As the price of goods and services rises, workers expect that their incomes will continue to rise at a similar rate and demand more to maintain their standard of living. Their increased wages result in a higher cost of goods and services, and this wage-price spiral continues as one factor induces the other and vice-versa.

A Look Back

A year ago, we knew the correct question, if not the answer: whether the tide of inflation would be a modest, easily managed wave or a dramatic flood that would roil markets, kneecap savers, and cause the Fed to rapidly hike rates, thereby imperiling recovery from the pandemic’s economic consequences.

When we published our piece in May 2021, the rate of inflation was 4.2%. According to U.S. Labor Department data published May 11, 2022, inflation has risen to a current rate of 8.3%, a slight drop from the previous month-to-month high of 8.5%.

For some of us, inflation’s comeback as an economic specter is a reminder of the mid-1970s, when an oil embargo led to 12.6% inflation and President Gerald Ford’s ill-fated “Whip Inflation Now” effort to spur a grassroots movement toward carpooling, adjusting thermostats, and planting vegetable gardens. (The public relations program’s most enduring legacy remains nostalgia for the red WIN buttons, T-shirts, and bumper stickers now in museum collections or forgotten boxes in the basement.)

A year ago, senior Federal Reserve official Lael Brainard recommended patience, contending that inflation’s surge was transitory and would subside once the pandemic faded in 2022, meaning the workforce would return and the global economy would recover as supply-chain congestion eased. At the time, CEOs and investors were skeptical.

Events have so far proved Brainard (now the Fed’s vice chair) to be mistaken. The public awareness of rising costs at the grocery market and at the gas pump has some perhaps searching for those old WIN buttons buried in the junk drawer.

In her May 2021 speech, Brainard 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.” Is that what happened?

To understand, let’s look at some underlying concepts.

Types of Inflation

Inflation reduces the value of current money in the future. Because prices go up, the value of a dollar today is worth less than it is in the future. The same dollar today will be able to buy fewer goods and services in the future. Money is always worth more now than it is in the future, particularly due to the investment capability of money.

Inflation is not only one thing. There are different types, based on the cause.

Demand-Pull Inflation occurs when there is more demand for a product than there is supply, which causes an increase in prices. When demand for output exceeds what the economy can produce, referred to as “too much money chasing too few goods,” there is competition to purchase the limited amount of goods and services. Buyers “bid prices up” again, causing inflation. This usually occurs in an expanding economy. An example of this occurred early in the pandemic when there was increased demand for latex gloves and masks without enough supply to go around. Consumers would pay more than usual to get those goods.

Cost-Push Inflation occurs when it costs more money to produce the same goods and services, so businesses pass those expenses on to consumers in the form of higher prices. The most common cause of cost-push inflation is an increase in the cost of production. If a business doesn’t raise prices while production costs increase, profits will decrease. Increased labor costs can create cost-push inflation, for example, when mandatory wage increases for employees come due. Cost-push inflation tends to be short-lived.

Demand-pull and cost-push inflation move in practically the same way, but they work on different aspects of the system. Demand-pull inflation demonstrates the causes of price increases. Cost-push inflation shows how inflation, once it begins, is difficult to stop.

Stagflation is characterized by slow economic growth and relatively high unemployment—or economic stagnation—which is at the same time accompanied by rising prices, i.e., inflation. Typically, these economic conditions don’t occur together. Unemployment and inflation tend to be inversely correlated: as unemployment rates increase, inflation usually decreases and vice versa. Of course, as the stagflation of the 1970s illustrated, this relationship isn’t always stable or predictable. Generally, stagflation occurs when the money supply is expanding while supply is being constrained.

What Can Be Done About It?

What we face now appears to be a mix of cost-push and demand-pull inflation; it is not stagflation.

To counter cost-push inflation, supply-side policies generally need to be enacted with the goal of increasing aggregate supply. To increase aggregate supply, taxes could be decreased, and central banks could implement contractionary monetary policies, achieved by increasing interest rates.

Countering demand-pull inflation could be achieved by the government and the Federal Reserve implementing contractionary monetary and fiscal policies. This strategy would include increasing the interest rate—the same as countering cost-push inflation because it results in a decrease in demand—plus decreasing government spending and increasing taxes, all measures that would reduce demand.

The goal of a contractionary monetary policy is to reduce the money supply within an economy by decreasing bond prices and increasing interest rates. Spending declines when there is less overall money to go around; those who have money want to save it instead of spending it. It also means there is less available credit, which can reduce spending. Reducing spending is important during inflation because it helps halt economic growth and, in turn, the rate of inflation.

The Federal Reserve could increase the Fed Funds Rate, the rate at which banks borrow money from the government; however, in order to make money, the Fed must lend it at higher rates. When the Fed increases its interest rate, banks then have no choice but to increase their rates as well. When banks increase their rates, fewer people want to borrow money because it costs more to do so. So, spending drops, prices drop, and inflation slows.

What Happened?

So, why did we arrive at the current situation? Two main reasons: the global pandemic and international tensions highlighted by Russia’s invasion of Ukraine.

At the beginning of the pandemic, as the world closed down and fewer people moved around, the demand for oil dramatically declined around the world. At one point, the value of a barrel of oil was negative. As the U.S. came out of the pandemic lockdowns, people took more flights, drove more frequently, and shipped more goods: thus, more demand for oil. Increased demand caused the price of oil to rise, even before the invasion of Ukraine. And as gas prices rose, inflation was also on the rise.

The global sanctions on Russia over its attack on Ukraine occurred against a backdrop of low oil inventories and persistent upward oil price pressures. Major producers have severed their relations with Russian oil producers, creating some supply-side shock to the overall amount of oil available. Because the largest oil companies are global, a supply shock anywhere affects the system everywhere. Thus, both oil and gasoline prices increased.

Poor weather has added to the challenges. Global food prices have reached record levels. Soybean prices are up 26% this year and have doubled their typical price. Corn is more than twice as expensive as before the pandemic and corn futures are up 37% this year. Wheat prices are up nearly 80% since July. The rise in these key ingredients is spilling over into the cost of producing foods. A United Nations group said global food prices hit a new high last month. The World Bank said it expects the conflict in Europe to boost food prices about 23% this year after a 31% climb in 2021 when snarled supply chains and bad weather jolted agricultural commodity markets.

China’s winter wheat harvest next month is one of the big uncertainties in a global economy already struggling with high commodity prices, particularly in regions heavily dependent on crops from Russia and Ukraine. If the Chinese harvest is bad in the coming weeks, it could drive food prices up further, compounding hunger and poverty in the world’s poorest countries.

Energy prices have been rising since before the war, prompting many fertilizer producers to slow production or close their factories. As fertilizer costs soar, many farmers around the world are using less, contributing to smaller harvests.

The U.S. is also in the midst of the worst bird flu outbreak in years. Millions of poultry and wild birds have been killed. And although the risk to human health is low, the impacts are trickling down to consumers and affecting the price of chicken.

What Is the Fed Doing?

As expected, in May 2022, the Federal Open Market Committee (FOMC), in a unanimous decision, raised the Fed Funds Rate by 50 basis points, to a range of 0.75% to 1.0%, the largest rate increase since 2000.

Beyond the rate hike, the Fed also formally detailed a passive balance sheet runoff plan to begin on June 1 to slowly remove liquidity in the financial system, with reduction caps starting at $30 billion in U.S. treasuries and $17.5 billion in mortgage-backed securities, and eventually double those numbers after August 2022.

While the policy statement indicated nothing new relative to market expectations, the key headline came from Fed chair Jerome Powell’s press conference, where he stated that a 75-basis point hike is not something the committee is actively considering at any meeting. So, increases of half a percentage point at the next few meetings, at the very least, appear more likely.

The big question in the $25 trillion U.S. economy is whether the Fed can achieve a soft landing for both inflation and economic growth. The market believes that if the Fed boosts interest rates too high too quickly, it will significantly increase the risk of recession. Currently, investors see aggressive rate hikes to as high as 3% by year-end based on future markets.

That’s well beyond the Fed’s neutral rate of 2.4%, which is the rate the Fed believes supports economic growth and employment without runaway inflation. We think the Fed, wary of overdoing it and triggering a recession, will shy away from increasing rates well past its neutral rate. With significant  higher yields this year, income generation from fixed income could bear watching closely.

Much of the deceleration in inflation from March to April 2022 resulted from a moderation in energy prices. But excluding the volatile food and energy categories, core inflation decelerated only modestly in April compared to March. Core inflation rose by 6.2% last month over last year, following March’s 6.5% increase.

Uncertainty about the Fed’s next moves—and about whether these moves will bring down inflation while avoiding triggering a recession—has stirred up heightened volatility across risk assets, bringing the S&P 500 down by nearly 17% from its recent record high from January 3, 2022.

Conclusion: Keep Your Seatbelt Fastened

We expect to see more volatility and a difficult path going forward. The Fed’s tightening actions can only decrease demand. They will not affect any of the geopolitical shocks to the system we have recently faced.

We believe inflation is peaking. However, we expect pricing pressures to remain high, with the rate of inflation remaining elevated. The Fed is expected to raise rates by 50 basis points at both the June and July meetings. After that, there are three more meetings left in 2022, beginning in September. At that point, we expect the Fed to continue to watch the economy as it tightens.

Investors should expect equity and bond markets to remain volatile over the near term or at least until there is more clarity regarding future actions of central banks to curb inflation and the potential impact those actions might have on economic growth as they take hold.

Inflation and stagflation can be unpleasant to deal with as a consumer and an investor. But knowing how to spot the signs of both can help you adjust your investment strategy to take them into account. The most important thing is to avoid being an emotional investor and panicking in the face of changing stagflation or inflation expectations.

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