Surging Inflation: Temporary or Durable?

By Steve Tsuchiya

In April this year, the prices of goods and services in the U.S. rose an astonishing 0.8%[1]. That’s in just one month.

This increase, measured by the Consumer Price Index CPI-U, is dramatic if you consider that prices rose on average around 2% over 12 months, over the past 20 years[2]. The Core CPI, which excludes food and energy, jumped 0.9% in April—the biggest one-month jump in 39 years[3].

Is this surging inflation temporary or durable? It matters because if it’s durable, spending power will be reduced, long-term bonds will suffer, and stocks—growth stocks in particular—may deliver below-average returns.

The sudden revival of the economy has created a strong demand for goods and services coupled with shortages of labor, raw materials, and finished products. These conditions have pushed prices up but are expected to moderate after shortages and supply-chain issues are resolved. However, other forces may be pushing prices up in durable manner: the increase in the money supply due to $5 trillion in fiscal stimulus along with the Federal Reserve’s policy of keeping interest rates low.

Factors that may suggest the recent surge in inflation is temporary

Home prices are back to the pre-Financial Crisis peak. Stock valuations are at their most expensive since the dot-com bubble of 2000 with the forward P/E of the SP 500 at 21.2 (as of May 13, 2021)[4]. At this valuation, stocks are “priced to perfection”, supported by low interest rates and the expectation of higher profits. (Current valuations are not as stretched compared to the peak of 2000 because the interest rates on Treasurys are much lower today.)

Unemployment is at 6.1% (as of April), leaving 8.4 million fewer jobs filled than at pre-pandemic level. But 4 million fewer people have stopped looking for jobs (i.e. dropped out of the labor force pool). This has spurred increases in wages: average hourly earnings rose 0.7% in April[5] and, in the leisure and hospitality sectors, they leapt 1.6%[6].

Tyson Foods, which produces about one-fifth of the U.S.’s poultry, reports that 15% to 20% of their plant workers haven’t been showing up to work due to childcare needs and coronavirus concerns[7]. Tyson also cites government stimulus unemployment benefits as a hurdle in obtaining new workers[8] because unemployment benefits can generate nearly as much income as job earnings. This is a transitory predicament because the current unemployment benefits will end in September.

Nearly a third of K-12 students are attending hybrid classes that mix virtual and in-person learning. But over 50% of students are opting out of in-person education in most cities[9]. This is putting a temporary damper on the growth of the labor force as parents of young children put off looking for work until in-person schooling returns in full or as more day-care centers reopen. Most educators believe most schools will fully reopen in the fall.

Airfares (which account for 0.6% of CPI-U) jumped 10% in April as people return to the skies[10]. Used car prices (2.8% of CPI-U) also increased by 10% in April and are up 18% from pre-pandemic levels[11]. Supply has shrunk and demand has increased in part due to people avoiding public transit. Among new cars, a global shortage of microchips forced auto manufacturers to cut production; the average new-vehicle sales-price is around $40,000, up nearly 10% in two years[12]. Restaurant food prices (6.3% of CPI-U) are rising. The Chipotle fast-casual restaurant chain raised prices on their delivered food by 4% in April.

Commodity prices are going up: lumber is currently four times costlier than at pre-pandemic levels; corn is up nearly 50% YTD (as of March); and copper hit record highs in May at $4.75 a pound.

These price-jumps of goods, services, and commodities may be transitory (as an example, gas prices, which soared over the past several months, decreased 1.4% in April). Unless….this burgeoning economic recovery, labor shortage, and supply-chain problems are masking other factors driving up prices.

Factors that may suggest the recent surge in inflation is durable

The U.S. government initiated $5 trillion in fiscal transfers and spending to preserve the economy in the face of the pandemic. As a result, the M2 Money Supply (bank deposits, brokerage money market accounts, and other cash reserves) surged 27%[13] since the start of the pandemic. The Paycheck Protection Program to businesses and stimulus checks to households have injected cash directly into the economy. This is in stark contrast to the government’s response to the Financial Crisis (2008-09); back then, the government gave money to banks—not to people. Increasing the supply of money that is “locked-up” in bank reserves is not as inflationary as directly giving people and businesses spendable cash.

With fiscal stimulus (directed by Executive and Legislative branches) being larger than monetary policy actions (directed by the Federal Reserve), the U.S. is relying more on politicians than the Fed to drive the economic recovery. The risk is that politicians may use inflation to minimize the burden of government debt instead of raising taxes.

On the monetary policy side, the Fed keeps the short-term interest rate at near-zero and continues to buy $120 billion in bonds each month to suppress long-term rates. The Fed is also encouraging inflation as part of their new framework[14] to achieve an average annual rate of 2% inflation over time—this means that the Fed is willing to let inflation run above 2% to even out the last decade’s sub-2% annual rate of inflation.

Another inflationary effect is the trend towards hitting the brakes on globalization. The Biden administration continues the protectionist agenda set by Trump. Moving some manufacturing back to the U.S. will lead to upward wage pressures, and thus, higher prices.

Finally, the labor shortage may be exacerbated by a demographic change in the world’s two biggest economies, U.S. and China. Low fertility initially increased the labor supply by encouraging more women to enter the workforce. But fertility has been declining for so long that there’s an increasingly smaller supply of workers[15]. Over the past 30 years, “the integration of China and Eastern Europe into the global economy, the entry of baby boomers into the workforce and rising women’s participation effectively doubled the labor supply of advanced economies, putting downward pressure on costs and workers’ bargaining power. This is now reversing, as dependents grow much more quickly than workers…”[16]

Conclusion: It’s foggy

The Fed thinks the recent increases in inflation is temporary. On May 12, Fed Vice Chair Richard Clarida said, “Over the next few months, 12-month measures of inflation are expected to move above our 2 percent longer-run goal, largely reflecting, I believe, transitory factors such as a run of year-over-year comparisons with depressed service-sector prices recorded last spring as well as the emergence of some supply bottlenecks that may limit how quickly production can rebound in certain sectors. However, under my baseline outlook, these one-time increases in prices are likely to have only transitory effects on underlying inflation, and I expect inflation to return to—or perhaps run somewhat above—our 2 percent longer-run goal in 2022 and 2023.”[17]

As of May 14, investors in Treasury bonds are forecasting inflation to annually average around 2.7% over the next five years[18]. The 5-year breakeven inflation rate[19], which provides this forecast data, is meaningful because it is, in essence, a poll of investors with a financial stake in an inflation-sensitive asset.

It is not yet clear if inflation is headed higher on a sustained basis. But it is prudent to consider the risks of it happening. At Generations Wealth, we are keeping a sharp eye on this issue and we are evaluating the investments in your portfolio to be prepared for it.

Appendix: How to track inflation in the U.S.

There are two measures of what has happened to prices: Consumer Price Index and Personal Consumption Expenditures. As for what may happen to prices, look at the Five-Year Breakeven Inflation Rate.

Consumer Price Index (CPI)

https://www.bls.gov/cpi/

There are two major components of CPI:

CPI-U tracks prices of all urban consumers. It’s also known simply as “CPI” or “Headline CPI” because it is the most popular inflation measure used by the media and financial professionals.
Core CPI excludes food and energy prices which tend to be volatile. The Wall Street Journal and other financial publications quote this measure along with CPI-U.

Personal Consumption Expenditures (PCE)

https://www.bea.gov/data/personal-consumption-expenditures-price-index

Like CPI, there are two major components of PCE:

PCE is the broad index.
Core CPI excludes food and energy prices.

PCE is rarely reported by the media but it’s important because the Federal Reserve uses PCE—not CPI—to measure inflation. As you can see on the chart, PCE has a tighter range than CPI because it uses a different methodology to analyze prices. Note: the essay does not quote PCE because the April data (to be published on May 28) was not yet available at the time of writing.

Chart: Comparison of PCE vs CPI-U. March 1, 2000 to March 1, 2021.

Source: Bureau of Labor Statistics; Bureau of Economic Analysis; Federal Reserve Bank of St Louis. March 1, 2000 – March 1, 2021.

Five-Year Breakeven Inflation Rate

https://fred.stlouisfed.org/series/T5YIE

As mentioned in the essay, this data shows what bond investors believe inflation may run annually for the next five years.

[1] Consumer Price Index for All Urban Consumers. U.S. Bureau of Labor Statistics. Consumer Price Index Summary April 2021. May 12, 2021.

[2] Estimate based on data of the U.S. Bureau of Labor Statistics.

[3] Since April 1982.

[4] J.P. Morgan Asset Management. Guide to the Markets. As of May 13, 2021.

[5] Unadjusted for inflation. Real (inflation-adjusted) earnings grew 0.2% in April. Real Earnings – April 2021. News Release. USDL-21-0858. U.S. Bureau of Labor Statistics.

[6] Unadjusted for inflation. Leisure and Hospitality statistics. U.S. Bureau of Labor Statistics. April 2021.

[7] “Tyson adds workers, breeds bigger flocks as chicken demand soars.” By Jacob Bunge. Wall Street Journal. May 10, 2021.

[8] Ibid.

[9] “No longer a “utopian idea”: How the pandemic could personalize education. By Bryan Walsh. Axios. May 5, 2021.

[10] Consumer Price Index for All Urban Consumers. U.S. Bureau of Labor Statistics. Consumer Price Index Summary April 2021. May 12, 2021.

[11] Consumer Price Index for All Urban Consumers. U.S. Bureau of Labor Statistics. Consumer Price Index Summary April 2021. May 12, 2021.

[12] “As chip shortage goes on, cars are scarce and prices are up.” By Tom Krisher. AP. May 13, 2021.

[13] As of March 2021. Board of Governors of the Federal Reserve System, M2 Money Stock [M2SL]. Federal Reserve Bank of St. Louis.

[14] Board of Governors of the Federal Reserve System. Statement on Longer-Run Goals and Monetary Policy Strategy. Adopted effective January 24, 2012; as amended effective August 27, 2020.

[15] “Demographics Help Squeeze Labor Supply”. By Greg Ip. Wall Street Journal. May 13, 2021

[16] Ibid.

[17] “U.S. Economic Outlook and Monetary Policy”. Speech by Federal Reserve Vice Chair Richard H. Clarida. At the “NABE International Symposium: A vision of the economy post COVID.” Washington D.C. May 12, 2021.

[18] Federal Reserve Bank of St. Louis, 5-Year Breakeven Inflation Rate [T5YIE]. May 14, 2021.

[19] Federal Reserve Bank of St. Louis: “The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities (BC_5YEAR) and 5-Year Treasury Inflation-Indexed Constant Maturity Securities (TC_5YEAR). The latest value implies what market participants expect inflation to be in the next 5 years, on average.”