Inflation has become the central topic in financial markets given its linkages to both bond and equity prices. It is also one of the most controversial and difficult-to-understand concepts. The Federal Reserve’s own model has been inaccurate for decades and they are now acknowledging this as they change their working assumptions. Therefore, we will not pretend to know all the answers either.

To keep things simple and to the point, there are two main manifestations of inflation, cost-push and demand-pull. Cost-push inflation is when prices of goods increase and are passed on to consumers. In recent years, globalization and technology have reduced input costs and put downward pressure on inflation. Demand-pull inflation is when excessive demand for limited goods drives prices up. This is seen in commodity cycles where demand exceeds supply, which drives prices up until supply can be replenished.

It is clear we are in another cyclical upswing and investors are beginning to speculate this cyclical upswing is different. Investors believe this one will be the start of a shift in which each cycle reaches a higher level of inflation than the previous cycle. There are a couple major obstacles preventing an imminent shift to secular inflation, or inflation that persists over a long period of time. We will cover these and then address a few things that may be different this time. Demographics suggest inflation should set a new low sometime between 2023-2025 as demand decelerates based on the changing age makeup of the population. However, after this timeframe demographics become supportive for sustained higher inflation via accelerating demand as millennials enter peak spending age groups. Debt-to-GDP is currently extremely high, and this has created a pull-forward which reduces future demand. In the absence of debt forgiveness, it will be extremely difficult to get sustained rising inflation.

What is different this cycle is the Federal Reserve is now pro-cyclical, and this will put more upside into this cyclical upswing. There are supply chain issues which should yield more cost-push inflation than recent cycles. Potential food spikes from global cooling could further increase inflationary pressure. Not mentioned previously, but fiscal policy geared toward lower income Americans will result in a higher monetary velocity due to their increased propensity to spend. Without going into details, this will be a boost to inflation this cycle. And lastly, housing is the biggest component in the consumer price index basket, and it looks poised to face more upward pressure than in recent cycles. Household formation is in a big upswing as millennials are in their prime buying years. However, existing home supplies are at record lows. The release valve is higher prices.

In conclusion, inflation is accelerating and has several components to suggest the cyclical peak could surprise to the high side. However, there remains significant over-capacity from the pandemic and a massive debt burden to limit the secular upside. Investors are noting that policy makers are much more open to discussing concepts like student loan forgiveness and universal basic income (possibly via continual stimulus checks). If policies along these lines become a reality, then it is possible to see demand spike for several years and manifest into a secular upswing in inflation. However, in their absence, inflation could drop much further than expected after it peaks and surprise markets in both directions in the coming years.

Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet.
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