More than any other topic today, inflation seems to be top of mind for many. We want to discuss inflation, highlight the reasons for the recent increase in inflation, and provide a long-term outlook for inflation. We have included an executive summary below.
In general, inflation occurs all the time. Inflation means that each year, your dollar buys a little less than it did the year prior. This effectively makes everyday items, from food to housing, cost a little bit more than they did the year before. Your ability to continue to purchase these items as they grow in price is referred to as your "purchasing power." One of the main goals of investing is to maintain, and grow, your "purchasing power." You do this by investing in assets like stocks, that grow your money at a faster rate than inflation erodes it.
Example, if normal inflation is 2%, your money will need to earn 2% just to keep pace with inflation. If your cash sits in a bank account earning 0%, you are actually losing 2% to inflation every year! If an investment returns 4%, you have beat inflation and then some.
It is the Federal Reserve's job to create a modest level of inflation. Typically, this has been a target of 2% of inflation per year. Why does the Fed do this? To stop deflation from occurring. If inflation is the increase in prices, then deflation is the decrease in prices. Why are decreasing prices such a bad thing? Well, if you knew that the price of a car was likely to go down next week, would you still buy that car today? Probably not. Now apply that same sentiment to every good across the entire country. If everyone anticipated falling prices, then spending would come to a standstill. With a pronounced decrease in spending, businesses would be forced to cut wages and let go of workers, the stock market would decline based on gloomy prospects, and the economy would grind to a halt. Deflation is bad.
Cause # 1 - Pent Up Demand
Thanks to the COVID-19 pandemic, everyone has been locked inside for over a year. As life has started to return to normal, Americans are making up for lost time in a big way. Family vacations are getting planned, dinner reservations are being booked, and cars are getting upgraded. There is a large amount of demand for these goods and an increase in demand leads to an increase in price.
Cause # 2 - Low Supply
While everyone was locked inside their homes, suppliers of everything from cars to computers pulled back their production. Shipping containers that are normally at the right place at the right time ended up being stuck in various ports. In short, a well-oiled global supply chain came to a screeching halt. As higher than normal demand meets lower than normal supply, prices for everything are being pushed up. If a room full of people are trying to buy a single apple, then that apple will go to the highest bidder.
Cause # 3 - Too Much Money
In order to stimulate the economy, the government printed money to provide stimulus payments. Interest rates have also declined making money cheaper to borrow. In short, there is a lot of money in our system that is chasing a low supply of goods at a time when demand is high. While easy to criticize the recent monetary and fiscal policies, it is best to keep in mind that stimulus payments went to unemployed workers and PPP loans went to businesses that were faced with layoffs or going out of business.
Presently there are two inflation camps. One camp thinks that the current increase in inflation is temporary, or "transitory," and that we will eventually get back to our normal level of inflation. The other camp thinks that increasing prices will persist and will lead to hyperinflation. If deflation is prices going down, then hyperinflation is prices going up drastically and for a prolonged period. Just like deflation, hyperinflation is bad. In a hyperinflationary environment, the value of your dollar loses purchasing power at an ever-increasing level. If normal inflation is 2-4%, a rise by 10% or 15% is hyperinflation. In this scenario, no one can afford anything, and cash drastically loses its value.
In order to answer the question of whether high rates of inflation will persist, or even turn into hyperinflation, it's helpful to look at financial indicators that expose the presence of inflation to begin with. Let's look at a few.
Baltic Dry Index
The Baltic Dry Index (BDI) tells us the average price paid to transport dry bulk materials across more than 20 different global shipping routes. This index has risen from 500 during the depths of the pandemic-led global recession last summer to over 3,250 in early May. But those prices have dipped back to around 2,800 in recent days and could mark the start of a decrease in price pressure. A decrease in the Baltic Dry Index means that global shipping is moving back towards normal, and the price the consumer pays for goods should eventually return to normal as well.
Semiconductors are the materials used in the production of computer chips. The most well-known semiconductor is silicon and is responsible for the name 'Silicon Valley'. As global supply of semiconductors declined due to the pandemic, the production of many items that contained computer chips had to be put on hold. The good news is that as global shipping has recovered, so has the supply of silicon. An increase in the supply of semiconductors means that the production of computer chips can resume, which creates supply and lowers prices for those goods.
Commodity Prices Move Lower
Corn, wheat, beef, and gold are all examples of commodities. The most "famous" commodity recently has been lumber. As the price of lumber skyrocketed in April and early May of this year, the cost to build housing went up tremendously. While some people chose to pay the higher price, others decided to halt their building projects altogether. Prices of commodities have started to trend back towards normal, lumber included. As the cost of commodities trends lower, so will the prices that consumers pay for these goods.
We are currently experiencing higher than normal inflation. Some of this is transitory inflation, meaning that it will pass. Global supply chains will work themselves out, supply will meet demand, and the flood of money will eventually get absorbed back into our economy. In this scenario, hyperinflation is unlikely to occur, but inflation in some form will likely continue to persist.
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