Night School December 2021: Inflation

Inflation is in the news every day. We see it first-hand at the gas station, the grocery store, and elsewhere. It clearly has captured the attention of both the public and investors. The number of Google searches for “stagflation” (a combination of a stagnant economy and high inflation) has spiked.

What is It?

But what is inflation, what caused this latest bout, and what are the implications, particularly for Federal Reserve monetary policy and for investors?

Inflation, of course, is when something gets higher—tire pressure, academic grading, even egos. Economic inflation generally refers not just to higher prices for a single item or a small number of items, but of widespread prices of a broad category (such as food) or across a whole economy. Inflation also usually refers not just to one-time price increases, such as of the minimum wage, but to a series of price increases over time.

The federal government estimates an overall rate of price increases across a broad range of items in the economy. The Producer Price Index (PPI) estimates price changes faced by producers of goods, such as the input costs to a car manufacturer including steel, paint, or plastics. The Federal Reserve (the Fed) uses the Personal Consumption Expenditures Index (PCE) to measure inflation at the household level, but the Department of Labor’s Consumer Price Index (CPI) gets most of the headlines. The CPI is based on a survey of 80,000 common items that are purchased by households. Recent prices are compared to previous prices, usually those from a year ago or from the prior month (which gives a better indication of recent inflation trends). There is also the core CPI, which excludes food and energy prices. An easy laugh line by market pundits is “I guess economists don’t eat, drive a car, or heat their homes.” There’s a good reason, though, for excluding food and energy prices; they are volatile and can make it difficult to discern underlying, broad price trends. It is critical for policymakers, specifically the Fed, to get the best information for their deliberations in setting monetary policy, such as where to set short-term interest rates (the Federal Funds Rate).

Prices don’t always rise. They sometimes fall (deflation), which is rare. They fell for four years in the 1930s, briefly during the 2008-2009 Great Recession, and they began to fall month over month during the first wave of COVID shutdowns in 2020.

Is a Little Inflation Good?

Economists and policymakers almost always want some inflation (the current Fed policy target is 2% inflation). Deflation can lead to an economic collapse, as happened in the Great Depression of the 1930s. When people expect prices to fall, they defer buying, which leads to production cutbacks, job losses, more price cuts, and so on, creating a downward spiral. The ideal might be to have stable prices (as in the early 1950s), but the economy is much too large and complex to be fine-tuned by policymakers. That is why the Fed targets some—but not too much—inflation in an economy that is not too hot (a hyperinflationary boom), not too cold (a recession or depression), but “just right,” as Goldilocks might say.

What Causes Inflation?

Inflation usually comes from two sources. Cost-push inflation comes from sharp increases in input costs for items that are used widely throughout the economy, such as oil. Producers try to pass those cost increases on to their customers. If customers are able and willing to accept that, increases in the PPI lead to increases in the CPI.

Demand-pull inflation stems from high demand from consumers relative to the availability of goods and services, such as when they have surplus income or when borrowing conditions are easy (low interest rates and accessible credit from banks).

Sometimes, there are both types at the same time, as in the 1970s, when oil prices rose twelvefold, widespread inflation was surging, and consumers spent heavily in anticipation of further price increases. Note, though, that the inflationary decade of the 1970s was the only one of high inflation over the last century. Since then, successive economic expansions have resulted in lower inflation and interest rates than previous cycles. We don’t think, however, that current conditions are at all like those of the 1970s.

Inflation and Fed Policy

Many observers are now clamoring for the Fed to tighten its policy by raising interest rates because inflation has jumped recently (as headlines remind us). We, however, think that an increase in rates might be a major policy error that could throw the economy into recession.

Consumer demand has been substantial, but this is an aberration. Massive federal stimulus spending during the pandemic resulted in a rise in personal incomes during an economic collapse caused by the first global pandemic in more than a century, when much of the global economy was shut down at times. This enabled consumers in the U.S., for example, to increase their spending on durable goods such as autos, appliances, furniture, home gyms, home offices, etc. by 40% over pre-COVID levels. An increase in personal income during a recession was unprecedented. There is an element of demand-pull inflation here, but one could argue that the huge spending merely pulled forward demand from the future. After all, how many Peloton machines,new PCs, large-screen TVs, bread makers, or new sofas does a single household need?

A more important element in the current inflation evidently is cost-push inflation that has been caused by temporary supply disruptions caused by COVID. The price of anything—including shares of stocks in the market—depends on the intersection of supply and demand. In the economy, demand tends to change much more quickly than supply. In the first round of COVID shutdowns, demand plunged, but supply was more inflexible than demand. Then, supply responded during the summer and fall of 2020 by cutting back output to match the (lowered) demand. But the unexpectedly rapid development of vaccines and the enormous injection of cash by the federal government caused demand to recover quickly—more quickly than supply. We’re still experiencing supply constraints at many levels—goods imports, labor, etc.—but there are signs of improvement.

The classic policy response to inflation—raising short-term interest rates to make borrowing more expensive for credit cards, mortgages, etc.—applies to reducing demand from demand-pull inflation. Household spending would fall with higher borrowing costs. In addition, higher rates would likely entice spenders to save money via investing in higher interest rate money market funds or bonds instead of spending.

We must note that we are struck by the inherent conflict between the economy and our values here. While low interest rates may be important to economic growth and the “just right” inflation rate, that same consumer spending is often harmful to the environment. It’s yet another struggle for social investors to grapple with during these complicated times.

Policy for Today’s Inflation

Demand-pull inflation is not the problem today. The Fed cannot do anything about the sharp rise in oil prices due to lower U.S. oil production, or spikes in agricultural commodities prices because of a drought in Brazil, or blockages of shipments in British Columbia because of flooding, or a backlog of containerships at the Port of Long Beach.

Furthermore, the stock market and the economy have never been so reliant on supportive Fed policy. When the Fed tried to “normalize” interest rates in late 2018 as the economy recovered, investors had a tantrum. The Fed noticed and actually lowered rates in 2019.

Final Thoughts

Remember, like many other economic indicators, inflation measures are retrospective, not predictive. And it is changes in the future that drive stock and bond markets. There have been many instances of high trailing inflation over the prior months (such as in the summer of 2008 before the Great Recession) that were followed by deflation the following year. Let’s revisit this topic six months or a year from now. The prevailing wisdom might well have changed by then.