As economies around the globe continue to recover from the pandemic-induced downturn, one of the topics receiving an ever-growing amount of attention is the prospect for a surge in the rate of inflation. Numerous predictions have been made in the financial media warning of imminent spikes in price levels and a return to an environment characterized by systemic inflation. And we have indeed seen a significant increase in inflation measures in 2021. The Federal Reserve’s preferred measure of inflation, the Core Personal Consumption Expenditures, registered a year-over-year increase in its latest report of 3.4%. This represents the largest increase since April 1992.
Much of the increase in the rate of inflation this year has been attributed to “transitory” factors such as supply chain bottlenecks and increased housing demand. These factors have indeed contributed to the increase in the rate of inflation. But there is a reason these factors are described as “transitory.” Housing has seen sales of new and existing homes move lower over the past few months to pre-pandemic levels. Increasing prices and tight supplies have both contributed to the recent weakness. Lumber, a key component of the housing industry, has seen its price decline substantially as well. Last week Random Lengths, which maintains a framing lumber composite index, saw that index recently decline to $1,010 from a high of $1,551 in late May. Agricultural commodities like corn and soybeans have also declined from recent highs although both are still substantially higher over the year-to-date period.
Another key contributor to elevated prices has been the aforementioned supply chain bottlenecks. For example, a shortage of semiconductors has been a factor. Once again, this situation is felt to be temporary as suppliers work to increase production.
In summary, it does appear that several of the factors contributing to the increase in inflation are already starting to moderate or have even reversed course with current prices declining from prior levels.
But what about the longer term? While numerous variables in the inflation equation are demonstrating they can turn quickly, both higher or lower, are there components that need to be addressed that lend themselves to more secular increases in inflation? In this vein the discussion focuses on government spending, prospective deficits related to increased spending and how those prospective deficits are financed.
In this regard we saw a significant increase in government spending in the United States as direct cash payments to consumers and increased unemployment benefits were provided to many as an offset to the impact of the pandemic-led recession. Now the focus has turned to substantial spending initiatives focused on infrastructure. Will this increase in spending result in higher interest rates and contribute to higher inflation as government borrowing crowds out private borrowers? The answer is that while this may happen, it will not in the near term. The reason for this relative near-term optimism is related to the increased revenue being generated as the economy continues to recover. For example, U.S. tax receipts have recovered from their early 2020 decline while final stimulus checks were issued two months ago and many states are now stopping the payment of extended unemployment benefits.
Financial markets are not yet sounding the alarm in anticipation of higher inflation as the five-year breakeven inflation rate provided by the Federal Reserve Bank of St. Louis exhibits a current reading of 2.3%. This is a higher level than we have experienced over the past several years but does not represent a level of price increases that could be defined as “runaway inflation.”
In conclusion, we do view the current increase in inflation as being primarily transitory. Rather than a two-to-three-month phenomena we believe the transitory period may extend beyond the anticipated two-to-three months. And, as always, we will remain vigilant in looking for signals that may motivate a change in our outlook. If this occurs, we will take the appropriate steps to align our asset allocations with our revised outlook and execute the necessary shifts within our proprietary strategies to reflect the migration to the alternative environment. Contributing to this effort is the collective experience of our investment team which includes several members who vividly recall the last period of prolonged meaningful rates of inflation.
Source: BTC Capital Management, Bloomberg LP, Ibbotson Associates, FactSet, Refinitiv, Federal Reserve Bank of St. Louis.
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