Your complete guide to inflation outlook in 2021 (Part 1)
Your complete guide to inflation outlook in 2021 (Part 1)
Inflation is determined by a basket of goods & services. Covid caused no signs of broad-based inflation. If you are worried about it, you have to point out where exactly it’s coming from...
Inflation, you know, that thing your parents tell you existed in the 1980s but you haven’t experienced throughout your life. One cannot think about financial returns or consumer prices outside of the context of inflation – a 15% return sounds great, until you hear that inflation is 20%. Inflation is unarguably a significant risk to rising stock markets and the economy in 2021.
In the next couple of emails, my co-author Will Carpenter and I will systematically recap the inflationary trends in 2020 and outlook into 2021.
Inflation, explained, in a basket
Inflation is the phenomenon of rising price levels, which corresponds to decreasing purchasing power of a currency. Generally, inflation is caused by two economic phenomena: 1) demand-pull; 2) supply-push. When demand in an economy surges far beyond available supply, this can “pull” prices upward with too many dollars chasing too few items. On the other hand, if some event restricts supply of a good, this can “push” prices for that good upwards.
In the U.S., inflation has been measured primarily through Personal Consumption Expenditures (PCE) and the Consumer Price Index (CPI). The two measures have different methodologies but usually yield similar results, with CPI typically running slightly higher. For the past decade, PCE has been stubbornly low, often coming in below the Fed’s target of 2%.
Both indices are calculated based on the measurement of a basket of goods and services. So, if you want to make a projection about inflation, you have to look into the CPI basket and see what parts are going up. 40% of the CPI basket are housing related and 20% are healthcare, so a significant portion are services, and only 30% are made of goods.
That is why the trade war’s impacts have had relatively small weights on inflation (since goods prices going up doesn’t matter as much), and also why Covid-19 has arguably been more deflationary than inflationary when the services sector is hit very hard and will not be picking back up soon.
During the pandemic, apartment rents declined significantly, and because housing has a weight of 40% in the CPI basket, this is really pushing down the overall inflation. Another statistic that you might find shocking is that 40% of the increase in core inflation this August was due to a 4% gain in used car prices year-over-year.
What we’ve been observing during this pandemic is that prices went up for some goods (like used cars, Purell, paper towels), but there are no signs of broad-based inflation. If you are worried about inflation, you have to point to us where exactly it’s coming from.
Did Covid-19 cause inflation? Yes and no.
Many of you have asked whether Covid-19 is more of a deflationary or inflationary shock. Our punchline is: Covid has caused inflation in certain narrow asset classes, but there hasn’t been broad-based inflation.
Used car prices and home building supplies were two items that have seen marked surges in prices due to Covid-19. See the chart below where used car and lumber prices are both graphed since 2015:
Both of these instances are most likely due to a combination of demand-pull and supply-push. Car inventories were scarce in the U.S. after most international importation of vehicles dried up in April. Homes have seen an uptick in demand most likely due to historically low mortgage rates around 3%, thanks to the Fed cutting short-term rates to near zero when the pandemic hit.
However, Covid as a whole, like other recessionary incidents, was largely deflationary. Quarantines and financial difficulties reduced consumer spending and aggregate demand. Below illustrates how core PCE had been mostly below 2% (red line) and showed a marked decline to around 0.92% in April. Since then, it has rebounded to around 1.40%.
Why hasn’t Fed’s money-printing caused hyperinflation?
You might wonder why we’re not seeing inflation even though the Fed has been “printing money” non-stop through its QE programs since 2008. The Fed has injected trillions of dollars worth of liquidity into the economy since March, but this money is mostly going into credit markets.
In monetary theory language – the Fed’s money printing has only created inflation in financial assets but not transactions in real GDP. Financial assets are inflated and equities are up, but the aggregate demand by the broader economy has not fundamentally gone up. Therefore, one could argue that Fed’s money-printing programs can only lift up asset prices but not consumer prices.
So, why should we care about inflation?
For the everyday consumer, it’s about having less purchasing power of money they use to buy goods and services. If inflation is growing quickly, many consumers might demand higher wages to mitigate the declining value of their earnings. Higher inflationary expectations also incentivize consumers to spend more in the present if they believe their money will be worth less moving into the future. This effect is sometimes useful in times when economic growth is desirable (like right now), and the Fed often tries to boost expectations to spur growth in consumer spending.
For the investor, high inflation can be the doomsday for any fixed income portfolio. Goods and services becoming more expensive erodes any fixed rate of return. The worst-case scenario is that price level growth rises above the fixed rates of interest being received from some asset in a portfolio (treasury bond, etc.) and then that asset quickly becomes highly undesirable to hold. This causes the prices of such assets to drop when inflation rises. High inflation is considered a sign of an “overheating” economy by the Fed, which could portend an increase in the Federal Funds rate (interest rate).
We should care about inflation, but for now we shouldn’t over-worry about it. Apollo chief economist Torsten Slok explained the cognitive bias of inflation quite well in a recent email:
Whenever we are in a recession, like we are at the moment, there is always a lot of fear of high inflation coming. Then once we come out of the recession, inflation expectations come down. In other words, markets are systematically wrong about inflation during recessions, and we see this cognitive bias play out again today.
To be continued…
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