By Dean Bosco Principal CLA T. 407.802.1225 Email
- Inflation is the highest it has been for more than a decade.
- Inflation is a normal part of the economic cycle, but can be concerning when it is caused by all three contributing causes of inflation: supply and demand issues along with a dramatic increase in monetary policy.
- The current administration may be drawing upon lessons learned from the 2008 – 2009 financial crisis.
- Don’t damage your financial plan by reacting emotionally to current headlines, but consider how events can play out over the next 12 – 36 months. Work closely with your tax and wealth advisors on your long-term investment strategy.
Over the past couple of weeks, we’ve been talking about the increased prices of commodities in the U.S. Lumber, computer chips, cars, houses — these rising costs could be a sign of a more troubling trend. Inflation is the highest it’s been in more than a decade, and some economists worry it could spin out of control. So, what’s behind the current rise in inflation?
Inflation itself is not bad
When the COVID-19 wrecking ball hit the economy last year, no one was thinking about inflation. It was clear the economic shock of social distancing and other restrictions was going to cause a major recession — and it did. What was surprising was that it was so short lived.
Now, the U.S. economy is growing fast. But this growth comes with a side effect: inflation. Prices for everyday items are rising rapidly, but wages are not keeping pace — so the money Americans earn isn’t stretching as far. But inflation isn’t inherently a problem.
Inflation is actually a very normal part of the economic cycle, and is imbedded in all economies all the time. The Federal Reserve, which is in charge of keeping the economy stable, doesn’t mind inflation as long as it’s low and steady. The Fed tries to maintain a 2% inflation rate, which most economists agree is reasonable. As long as it’s consistent from one year to another, people can base their financial plans around it.
A new breed of economic activity
Inflation becomes a problem when we start losing track of where it’s going, and it becomes a lot harder to navigate the economy. Economists’ concerns heated up earlier this year when we suddenly saw microchip shortages for cars, lumber prices going through the roof, and other commodity prices rapidly increasing.
At the same time, we started seeing real-world implications of these changes. We got a big wake up call when the Consumer Price Index (CPI) report was released this month, showing that consumer prices rose 4.2% in April — the biggest year-over-year since 2008. At the same time, the May Jobs Report was significantly off its target of 1 million jobs, and only came in at 266,000.
In real-world terms, the 4.2% inflation rate means that costs of daily goods and services have more than doubled from what they were a year ago — and corresponding wages have stayed flat, so our money isn’t going as far as it used to. The rapid rise in inflation is concerning, as we don’t know what levels it will reach or for how long.
Why inflation happens
There are three main reasons why the “bad kind” of inflation happens. The first is supply issues. The second is demand issues. And the third is when a lot of money gets pushed into the economy and the value of the currency goes down, à la monetary policy.
Salad prices are going up in the Bay area. What happened was this: restaurants were shut down during the pandemic, so lettuce growers started sending all their produce to supermarkets (deemed essential during lockdown). Now restaurants are opening again, but they don’t have any lettuce because the supply chain was disrupted. So, they’ve increased salad prices to make up for the reduced quantities.
Because the economy is reopening and supply chain issues aren’t just fixed overnight, there are a lot of logistical challenges to overcome in order to get things back to normal. And on top of that, the supply chain derailment has been exacerbated by an increase in demand.
The first concern is something economists call pent-up demand. How many millions of people have been sheltering in place over the last year — just waiting for the day when they could go out again with friends, or go to the movies or a restaurant or away on vacation? Now, with restrictions ending, people are going out and spending money all at the same time. This leads to a huge spike in demand for goods and services, which in turn leads to inflation.
Compounding the pent-up demand is the fact that people have a lot of money to spend right now, partly because of the government’s three economic stimulus bills. This additional discretionary money is allowing people to get out there and spend, spend, spend — more than they might have done otherwise!
When the Federal Reserve creates “new” money and pumps so much of it into the economy that the money itself begins to lose its value — it forces people to use more of it to buy the goods and services that sustain their daily lives.This is what some economists believe is beginning to happen. The Fed is pumping billions of dollars into the financial system by buying treasury bonds and mortgage-backed securities from banks and financial institutions.
The Fed has said repeatedly that these trends are transitory and are in direct correlation with the impact of the pandemic and, therefore, will eventually work themselves out in time. But should we be worried?
A tricky situation
If inflation becomes intrenched, then the Fed has to cool things off by raising interest rates, thereby slowing economic activity. This could then cause a recession and increase unemployment. If the Fed has to clamp down on economic activity to fight off inflation, it’s likely to hurt the very people who need it and the Biden administration is trying to help.
So, the Fed and the Biden administration have to walk a fine line. Not enough stimulus means people may not have enough money to buy food. Too much stimulus means the price of food goes up and the stimulus money isn’t worth as much. The question then becomes: Is the stimulus really individuals and families with lower income , or is it just a transfer mechanism to the businesses that sell them their goods and services?
One possible blind spot is that policy makers, including the Fed, often look to the last economic crisis for how to respond to the current one. The lesson learned from the 2008 – 2009 financial crisis was that — after pumping trillions of dollars into the economy — the inflation everyone was worried about never happened. So perhaps the government could have been even more proactive. The Biden administration seems to have taken this lesson to heart, and has said all along that it’s better to do too much than not enough.
It could be we’re seeing a new breed of economic activity that may prove to be more difficult than the same old monetary policy remedies can manage. But right now, the signals of whether or not there is a real inflation problem are mixed at best. We have to watch how things unfold to know what we are getting — and to know what the right response ultimately needs to be.
In uncertain times, remember that making investment decisions based on emotion is ultimately detrimental to your long-term investment strategy. We continue to recommend staying the course. Look to your personal financial plan and work closely with your tax and wealth advisors to consider which allocations can help you achieve your personal risk-adjusted return over the long term.