Inflation – Transitory or Here to Stay
When I began my career in 1978, inflation had been ravaging the economy. The inflation rate averaged 6.8% in the 1970s peaking at 11.3% in 1979. It reached 13.5% the following year before the Federal Reserve, led by Paul Volcker, raised the federal funds rate to slow down the economy and suppress the runaway inflation.
Since the late 1980s, inflation has been relatively tame. In fact, many economists were more concerned about the deleterious impact of deflation or declining prices that devastated asset values during The Great Depression. Most recently, the stated policy of the Federal Reserve is to provide support for a 2% average inflation rate and, perhaps, allow itDue to a confluence of factors resulting from the economic damage imposed by the pandemic, inflation has recently exceeded this 2% threshold. In May, the core inflation rate, which excludes food and energy, was up 3.8%. The main inflation index that includes these sectors rose 5%.
The raging debate among economists and strategists is whether this significant rise is transitory and will subside as the economy recovers or is more structural in nature and might be embedded into the fabric of the economy.
The late renowned economist Milton Friedman, famously stated that “Inflation is too much money chasing too few goods”. As Friedman had predicted, due to major disruptions in the supply chain and the pent up demand by consumers who delayed purchases during the pandemic, prices for many goods and services have skyrocketed. A prime example is the 30% increase in the price of used cars that resulted from the shortage of available new cars. As COVID restrictions have been relaxed, demand has also surged for services such as dining and traveling. These trends have caused oil prices to soar and wages for lower paid workers to rise. Meanwhile, consumers saved $2.4 trillion during the pandemic from a combination of stimulus checks, unemployment benefits and a lack of spending. This combination of strong demand and weak supply created this inflationary cycle. As cash is drawn down and supply chain issues are resolved, it is likely that the inflation rate will moderate.
Friedman also believed that inflation can result from an increase in money supply that exceeds output. With the Federal government printing money in the trillions to support the recovering economy and more likely to come in the form of infrastructure spending, output may continue to lag the increase in money supply. If this trend continues, higher inflation may be baked into the economy for years to come.
While I have provided you with both sides of this debate, the final verdict won’t be known for quite some time. In managing portfolios, it is my responsibility to consider the possibility of either outcome and plan accordingly.
Despite the challenging weather throughout the country, we hope that you are enjoying summer.