What’s the Deal with Inflation?

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If you have turned on any business news channel in the last 3-6 months, odds are you have heard repeatedly that inflation is coming, or is already here, in the United States. We have been telling our clients to expect inflation to be the next “big” headline news story. And it seems that no matter who you ask, there are only two mindsets regarding inflation: deniers and doomsdayers. Personally, I fit somewhere between the two, and below are some of my thoughts on inflation and what we may see in the short and long term. 

Chart, histogram

Description automatically generatedInflation, as you most likely already know, refers to the general rise in price levels. Many different metrics are used to define inflation, but the most common is Consumer Price Index (CPI). CPI is most commonly used as a percentage change from the prior year, also called a Year-over-Year comparison (YoY). Below is a thirty-year chart of United States YoY CPI: 

As you can see, the most recent Year-over-Year reading is 5.39%. Here are my takeaways. Year-over-Year data can sometimes be deceiving. For example, in April of 2020, inflation numbers were very low. In fact, we were on the brink of deflation (prices falling). Logically, if your comparison basis is low from a year ago, and you are returning to a more normalized inflation reading, this will cause an artificially inflated growth number, in this case, CPI. For this reason, on the chart above, you will notice large drops followed by large spikes. It’s just the way the statistical measure works. See below: 

Steady 2% Inflation 
 Price Index (CPI) One Hundred $ 
End Year 1 2% $102 
End Year 2 2% $104.04 
Uneven Inflation (what we are seeing) 
 Price Index (CPI) One Hundred $ 
End Year 1 0% $100 
End Year 2 4.04% $104.04 

As you can see, in both of these scenarios, the resulting price level is the same, but in the Uneven Inflation Model, the inflation rate, or CPI, was dramatically higher. This is what we are currently seeing in our CPI readings. 

Now, by no means am I suggesting inflation is just some statistical anomaly. I am human too! I fill my gas tank, buy food and clothes, recently purchased a home, and have seen lumber prices at Home Depot. Inflation is real, but two questions come to my mind: 

  1. Is it permanent? 
  1. How high do prices go? 

Question 1: This is the big question, and the question Federal Reserve Chairman, Jerome Powell, gets asked daily. The Federal Reserve believes that inflation is “transitory”, or not permanent. To an extent, I am in agreeance. To an extent, I disagree.  

There are areas of inflation that we are currently experiencing that are undoubtedly transitory, and we have seen the laws of supply and demand already begin to regulate some of their respective markets. Prime examples: lumber. See below: 

Chart, histogram

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There are many areas of the “materials” market where there was a dramatic discrepancy between supply and demand. Low supply due to the COVID factory shutdowns, followed by a reopening economy, caused rapid price increase, followed by rapid declines as anomalies normalized.  

Alternatively, there are some areas of inflation that I believe could be here to stay. These include food and clothing, consumer services, gasoline, and even housing (I touched on millennial home buying trends in a previous post). There are many theories on “sticky” inflation, but this is how I look at it in its simplest form. We have a labor issue, with 9.2 million non-farm job openings in the United States. To entice workers to return to the workforce, wages have to and will rise. Once these wages rise, they will not be taken away from employees unless there is some economic downturn resulting in an oversupply of workers. These higher earnings, coupled with easy monetary and fiscal policy from the past 1-2 years, will keep prices inflated. Companies will pass on the extra labor costs to consumers. 

Question 2: How high do prices go? Are we heading for Zimbabwe-like hyperinflation? I think not. But, there are some price anomalies, like lumber, that seemed to get a little out of control. Those anomalies are temporary. The Federal Reserve has instated a policy to let inflation run slightly hotter than their 2% target in an effort to achieve maximum employment. My guess (and that’s all it is, an educated guess!)? We see moderate inflation moving forward in the range of 2.5-3% annually, with the Federal Reserve slowly cutting back on their easy monetary policy. Time will tell! 

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