Where Inflation Goes To Hide

It has been a half a century since consumers were last seriously concerned about inflation, but supply shortages and rising prices have some harkening back to the gas lines and stagflation talks that dominated financial discussions the 1970’s. In this article, we look at the case for continued growth in inflation, explain how officially reported numbers may be lower than the marks actually being felt by consumers, and examine further considerations for inflation conscience investors.

From a monetarist perspective, broad inflation (P) is a function of the money supply (M), the speed at which this money circulates the economy (V), and the quantity of goods and services in said economy (Q, MV=PQ). In this sense, the COVID-19 response has been the perfect storm for inflation: approximately 25% of the total dollars in existence have been created since COVID first hit the United States, and lockdowns prevented commensurate (or for that matter even positive) growth in goods or services. The only saving grace thus far has been a drastic reduction in the velocity of money (see Figure 1 below). If consumers normalize their spending habits, a return to pre-pandemic velocity levels could spell further increases in prices.

Figure 1: Velocity of Money And Money Supply

Data Source: FactSet

In addition to the “demand-pull” inflation driven by the stimulus packages, we are also facing pressures from “cost-push” inflation. Supply chain disruption and increases in labor costs in both the developing and developed countries have pushed the production costs higher. Over the last one and half years, producer prices have continually lead increases in consumer prices (see Figure 2 below).

Figure 2: YoY Growth In CPI Inflation

Data Source: FactSet

While these points imply that inflation has more room to run, it is important to recognize that the impacts of inflation on various groups in society may differ. For example, the methods used by Bureau of Labor Statistics (BLS) to compute CPI may underestimate the cost of living for younger generations. In the late 1990s, the Bureau of Labor Statistics started counting houses as capital goods rather than consumption items. To account for housing costs, the BLS now uses “owner’s equivalent rent” (OER) in their calculations by asking homeowners to guess the rental value of their (unfurnished) home, minus any utilities. This change is noteworthy since housing costs make up a plurality of most people’s expenditures, and since OER, the single biggest input in CPI, is reliant on guesses from homeowners who are both divorced from the rental market and heavily influenced by their mortgage rates. Such influence is almost a built-in mechanism to mute inflation measurements– the same easy money policies which lead to inflation will decrease borrowing costs, leading to lower monthly mortgage payments despite higher down payments.

Another mechanism which mutes inflation is improvements in technology. If Moore’s law is to be trusted, then technological innovation is an exponential process. This is relevant because of the way the BLS calculates inflation. For example, if the cost of a phone increases by 10%, but the technology on the phone increases by 11%, the phone is technically considered a deflationary item in their basket of goods. On one hand this makes sense, but it also discounts our naturally evolving standards of living. The same thought process can be applied to the rising costs of education– in many jobs, what was once considered a bonus is now a prerequisite. This means that the 6% weighting that the BLS gives education may make sense when averaged across a population, but these costs are disproportionally being borne by young professionals. The two most often cited financial obstacles of this demographic are home ownership and student loan debt, both of which have greatly outpaced inflation (see Figure 3 below).

Figure 3: Price Increases of Education and Home Ownership Relative To Broad Inflation

Data Source: St. Louis Fed and www.bls.gov

This shows that, depending on the demographic, officially stated inflation can potentially be magnitudes lower than the costs actually being felt by consumers. With this in mind, there are two variables that any investor should be contemplating regarding inflation: how bad and how long? What does Fed Chairmen Powell mean when he repeatedly suggests that inflation will be “transitory”? Does he mean the growth in inflation will be transitory (i.e. the high prices we see today will continue to increase by ~2% a year instead of the 5% growth we’re seeing now) or that price increases themselves will be transitory (i.e. we will see a period of deflation, whereby the high prices we see today return back to levels considered “normal”)? When does he expect this to happen? The answers to these questions may help guide investors how best to position their portfolios in both the short and long-term.

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