If you have tried to buy something like a car or washing machine lately you probably know firsthand about the challenges of lean inventories & price pressures and are not surprised by the surge in inflation readings that have filled media headlines. Inflation is not only salient because it affects businesses/consumers but also because of its effect on interest rates, and therefore asset prices. But inflation is also an economic phenomenon in the sense that it is maybe the most discussed financial topic but also the least understood by forecasters when applied to real world developed economies. In our January 2021 Economic Outlook we highlighted runaway inflation as a key risk for the economy in the New Year, but also why the long-term picture is not as clear.
The view by the Federal Reserve and one which we largely share is that inflation will be transitory driven by supply chain bottlenecks … but transitory can feel like a long time. When you essentially turn off & turn back on the World economy it will take some time to find balances. Just like the economic data stunned us during the lockdown, the same is happening now with reopening. Very aggressive fiscal and monetary policy has led to a burst in reopening and many parts of the supply-side of the economy are simply trying to keep up. The hope is that shortages will start to ease as supply catches up to demand, but this won't happen overnight. We think we are at least several quarters away from the economy feeling more balanced. If we had to step out and make a forecast on inflation it would be one of phases: 1.) temporary burst in inflation as shortages from shutdowns drive up goods prices and reopening supports services pricing 2.) softening of inflation as economic growth rate peaks in second half of year and supply chains relieve themselves of bottlenecks 3.) labor market pressures push core inflation modestly higher at a faster pace than pre-covid due to wage inflation.
That final part is the one that concerns markets. Like with most things there are “good” and “bad” inflation. The market tolerates demand-driven inflation and can look past supply chain/margin pressures when it is being pushed by strong consumer demand. Wage inflation tends to worry markets more because it is stickier than goods inflation, meaning it tends to last longer and could persist past the peak in demand growth. Right now investors are hoping a full reopening of schools and a cliff on UI benefits later this year will provide a pool of workers who will keep a lid on wages which would bode well for equity markets.
And finally let me frame the inflation narrative this way: Markets are prone to greatly exaggerating things on both the up and downside. Let’s not forget that 14 months ago you literally had to pay someone to take your maturing oil futures contracts off your hands and Central Banks & Governments were doing everything they could to stimulate the economy to prevent a plunge into deflation territory. Looking back it could be argued that was an overreaction as it was the peak of shutdowns and the economy was out of calibration. Fast forward to recent weeks and pictures are going viral of people filling up plastic bags and water bottles with gasoline (maybe for different reasons but trying to illustrate a point). And if you're looking to buy a car you are pretty much going to pay sticker price and may not even get the color you want. Could it be possible that today's hyperinflation worries could be looked at in hindsight as the flip side of the economy calibrating itself as it reopens? That would probably be the way I lean. But in the coming quarters we will begin to see whether the pressures are really transitory or whether a structural shift has taken place in the economy leading to a long-term upward inflection in inflation.
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