Telemus Special Market Commentary: The Great Inflation Debate

Inflation has gone from being a dull topic that only those over 50 can truly appreciate, to one that is now front and center to any economic or financial debate. Concerns around the prospect for inflation stem from the aggressive fiscal and monetary stimulus that has grown the U.S. money supply by roughly a third since the start of the pandemic¹. In addition, the conditions of the pandemic have resulted in shifts in behavior as spending has shifted away from services and become more concentrated in the consumption of goods. Lastly, the consumer price index (CPI) has started to spike higher due to the fact that year-ago levels incorporated the recessionary period from start of the pandemic, and hence have a low base of comparison (referred to by the Fed as a base effect).

As the economy is starting to reopen, it is becoming more broadly recognized that we are likely to see heightened inflation during the second and even third quarters of 2021. The debate around inflation is now starting to center around what will transpire as we head into 2022 and beyond, once we lap some of the short-term, or transitory impacts, that have influenced recent inflation reports. We believe the right way to frame the debate around inflation is not, “what will the inflation rate be?” (no one knows), but rather, “where is it likely to trend and how that might impact consumers and investors?”.

Current Conditions

In the last couple of months, the U.S. economy has begun to see an acceleration in the rate of inflation. The Consumer Price Index (CPI) rose on a month-over-month basis 0.8% in April and 0.6% in May. The trailing one-year inflation rate now sits at 5.0%, ahead of the Fed’s goal of averaging 2%.

Looking more deeply at the numbers, several items that we and others would deem transitory are having an outsized influence. These items include used car prices, airfare, rental car rates, auto insurance rates, and hotel pricing. The price increases in these items are directly related to the reopening of the economy and we would not expect the rate of price increases in these categories to persist for an extended period of time. Based on our analysis, we believe roughly half of the increase in the May CPI can be transcribed to these transitory elements.

There are clearly some categories experiencing greater price increases than others, but in general prices are rising. Supply chain challenges and labor shortages are leading to record low inventory levels. This can have an inflationary impact as suppliers are not incentivized to offer price concessions to boost sales. In addition, categories that had been challenged to take price increases prior to the pandemic, such as apparel, are now experiencing price gains. The combination of no longer having deflationary pressures in items like apparel, and less incentive to sell goods at sale prices is having a positive impact on the inflation rate as there are fewer negative offsets to those categories experiencing positive price increases.

Some argue that in order for inflation to remain persistent, and not transitory, it must translate into higher wages, giving consumers more purchasing power. We have begun to see some signs of wage pressures building. More recent headlines, such as McDonald’s raising its hourly wages, serve as an indicator this may be the start of a broader trend. The one wildcard is that we continue to have high unemployment and employers may elect to hold off on passing on higher wages until excess unemployment benefits lapse. Lower unemployment benefits may encourage more workers to re-enter the labor force and employers may be reluctant to pass on higher wages if an eventual influx in labor supply leads to an easing of wage pressure.

Looking Forward

Given supply chain challenges, low inventory levels and base effects, we feel inflation readings are likely to stay elevated through the third quarter. However, we may begin to see the rate of change slow, similar to what transpired with May’s reading decelerating from the pace in April. We think the biggest test will come in the fall as more time lapses from the latest stimulus payment and we hope to see the unemployment rate continue to fall. We will also begin to see evidence in how businesses are choosing to navigate conditions, and whether they are spending to replenish inventories and how aggressive they choose to invest in their businesses.

Our base case expectation is that inflation could trend in the 3% range, but with a wide degree of potential variation. We see greater risk to be the upside, where inflation could be much higher than the Federal Reserve’s 2% long-term target. The St. Louis Fed’s price pressure measure currently forecasts an 83% probability that inflation will exceed 2.5% over the next 12 months².

Given that there is a wide range of potential outcomes with inflation, we don’t believe investors should anchor to one expectation or another. Rather, they should develop an understanding of the conditions and risks that exist and work with their advisor to best assess their portfolio’s sensitivity to various inflationary outcomes. In general, those with longer investment horizons and less immediate spending needs are going to be less vulnerable to inflation.

¹As of June 2021 https://fred.stlouisfed.org/series/WM2NS

²As of June 2021. https://fred.stlouisfed.org/series/STLPPM

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