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Wednesday, July 21, 2021

Da Bear's Perspectives: Will High Rates of Inflation Return?

 

Da Bear’s Perspectives

By Ron A. Rhoades, JD, CFP®

Associate Professor of Finance, Gordon Ford College of Business

Director, Personal Financial Planning Program, Western Kentucky University

Financial Advisor and Content Specialist, ARGI Investment Services, LLC

To contact Ron, please email: bear@argi.net.

 

Will High Rates of Inflation Return?

As I traveled over the past two months visiting colleagues and clients across the eastern United States, it was indeed a pleasure to get out. And I had a greater appreciation for the small things – the laughter of children, the smiles on the faces of often-overworked servers, and greetings of hotel desk clerks. My biggest takeaway – it sure was nice to get out and connect with other people again!

“Da Bear’s Perspective” is a new publication designed to offer insights into both current topics of interest to investors, as well as insights into obtaining the most out of life. I hope to educate and inform through a “deeper dive” into many of the economic and capital markets issues. And, at times, I hope to share insights that may lead my readers to lead more fulfilling lives.

In this edition, I focus on a question often posed as I met with colleagues and clients – fears of high inflation.

Executive Summary

Much of the recent rise in prices – particularly in used cars and housing – is likely temporary in nature. In particular, used car prices – a major contributor to the past year’s rate of inflation – will likely fall over the next two years. Home prices will likely not increase as much, as more inventory from builders becomes available over the next few years. This suggests that much of the recent inflation seen – 5.7% from June 2020 to June 2021 – is “transitory.”

However, the surge in commodity prices (which prices can swing widely over time), and the substantial increase in wages, suggest that the rate of inflation may continue. The large increase in the money supply can also lead to inflation, particularly if the velocity of money (i.e., the rate of money changing hands in the economy) picks up if interest rates rise (and banks have more incentive to lend). A wage-price spiral, last seen in the 1970’s and 1980’s, may serve as a trigger which leads to higher interest rates.

In Da Bear’s view, a 25% or greater chance of non-transitory (embedded) inflation exists.

Contents

Executive Summary. 1

Inflation Basics. 2

How Has the Rate of Inflation Changed Over Time?. 4

Should We Be Concerned About Inflation?. 5

Is Inflation High Today?. 5

Is the Recent Surge in Inflation “Transitory” or “Embedded”?. 7

Money Supply, the Velocity of Money, and Inflation. 8

The Potential for a Wage-Price Spiral 9

On the Many (Other) Factors Affecting Inflation. 11

Inflation and Your Investment Portfolio. 12

 

 

Inflation Basics

Inflation is typically measured, in the United States, by the U.S. Bureau of Labor Statistics, through a measure called “Consumer Price Index for Urban Consumers” (“CPI-U”). CPI-U is a measure of the average change in prices paid by an urban consumer for a certain “basket” of goods and services. To determine this statistic, each month shoppers are sent out across the country to measure prices, and the data is then utilized to determine the rate of inflation.

As seen in the chart below, housing (the prices of single-family homes and condominiums, and rents) accounts for over 42% of the measure of inflation. Medical care only accounts for 8.87% of CPI-U.

“Core CPI” is the measure of inflation that excludes food and energy prices, which can be quite volatile. While policy makers often pay attention to Core CPI, for consumers CPI-U is the better measure to watch.

Your personal rate of inflation – i.e., how much you spend for the same basket of goods and services – can vary significantly from the government’s measure. If your consumption patterns are different, your personal rate of inflation will be different.

For example, suppose you own your own home. If you have a fixed rate mortgage, or no mortgage at all, the cost of your home does not vary significantly, and your personal rate of inflation may be lower. Refinancing a mortgage to a lower rate can also cause you to lower the cost of home ownership. However, certain housing costs, such as taxes, insurance, and maintenance, can still increase over time.

Likewise, if you spend a lot on medical care, and the costs of medical care increase substantially, your personal rate of inflation can be higher. For example, health care spending increased substantially from 1980 to 2008, but since then health spending growth has slowed to a similar rate as the overall measure of inflation.[1]

How Has the Rate of Inflation Changed Over Time?

The rate of inflation (CPI-U) has been modest over the past decade. But this was not always so. In the 1970’s and 1980’s, the rate of inflation was much, much higher, as seen in this chart from EconoFact:


Here are the rates of inflation by decade:

 

Should We Be Concerned About Inflation?

Inflation is always a concern. Inflation is the unstoppable economic force that slowly and steadily drains the purchasing power from your dollars by driving the cost of everything up over time.

Modest inflation, such as that desired by the Federal Reserve’s target of 2%, is not troubling. It facilitates the repayment of long-term debt, provided incomes increase over time. It also facilitates a rate of return for savers in CD’s, bonds, and other fixed income investments. A modest rate of inflation also stimulates spending by both businesses and consumers, which in turn can drive economic growth. And modest inflation allows wages to be adjusted upward.

But very high inflation, as seen in the late 1970’s and early 1980’s, can be devastating – and difficult to stop – once it begins. High rates of inflation create economic uncertainty, which can lower investment by companies. Lending by banks becomes more precarious. The foregoing impacts (lower investment, lower lending) can lessen economic growth. For consumers, savings can fall in value (the “real return” – also known as the “inflation-adjusted return” – on savings can be negative) when inflation is high. If wages don’t keep up with inflation, “real wages” (wages, less the rate of inflation) can go lower. And, if a high rate of inflation occurs in the United States, but is less prevalent in other countries, over time inflation can reduce our international competitiveness.

Is Inflation High Today?

A high rate of inflation is present, today, when comparing prices now to prices a year ago.

The U.S. Consumer Price Index (CPI-U), the nation's key inflation measure, jumped 0.9% in June 2021 from the prior month; this was the largest one-month increase in 13 years. Over the last 12 months, prices were up 5.4%, the biggest jump in annual inflation in nearly 13 years.[2]

The recent surge in inflation is driven by many short-term factors, including:

·       Car Prices. The rise in new and used car prices, due to shortage of computer chips for new vehicles, and the disruption in 2020 of rental car fleets. Surging prices of used cars and trucks accounted for more than one-third of the inflationary spike seen over the past year. The retail price of used cars jumped 10.5% between May and June, following a 7% jump the month before. However, The prices dealers pay for used cars at massive auctions across the country dipped in June 2021 after hitting record highs for much of early 2021, according to the Manheim Used Vehicle Value Index.[3]

o   The 10.5% increase in June in used car prices was the largest one-month jump in records that go back nearly 70 years, and a stunning 45.2% increase over the last 12 months. New car prices are also up 5.3% over the last year, hitting record levels.[4]

o   Car prices are being driven up by strong consumer demand for cars, along with a limited supply due to a shortage of computer chips needed to build the cars. Rental car companies, a key seller of used cars, already sold off much of their fleet of cars last year to raise cash during the pandemic and now don't have enough cars to rent.  Yet, as the supply issues are resolved over time, car price increases are likely temporary. Expect the prices of both used and new cars to fall during 2022 and 2023.[5]

·       Home Prices and Rents. Due to low interest rates, demand from millennials reaching peak homebuying age, and a general shortage of single-family homes, housing prices have risen dramatically recently. The National Association of Realtors estimated the rise of existing home prices at 15.4% for the 1st quarter of 2021, from a year before. New home prices increased 5.1% from the year prior.[6] Prices, however, are projected by CoreLogic economists to only increase 3.4% over the next year (from May 2021 to May 2022), as affordability challenges hit some buyers and cause a slowdown in price growth.[7]

o   Soaring home prices have had the effect of also raising rents, with a bit of a lag present. Data from Apartments.com shows average rent prices are up 7.5% year-over-year, which is three times the normal growth rate. CoreLogics’ April 2021 data shows a national rent increase of 5.3% year over year, up from a 2.4% year-over-year increase in April 2020. Rent prices vary widely, however, with rents actually on the decline (on average) over the past year in Chicago and Boston, while even higher rent increases than the national average were seen in many areas of Arizona, Nevada, Georgia, and Texas.[8] The future of home prices and rents is uncertain, as demand may be affected by many factors (including mortgage rates, demographic trends, etc.

·       Oil prices. The following chart shows the 5-year trend of oil prices:

Source: Crude Oil Price Today, retrieved 7/13/2021.

As seen, the substantial dip in oil prices due to decreased travel and decreased economic activity at the inception of the COVID-19 pandemic has, over the past year, been negated by jumps in oil prices. This has occurred largely via production cuts by OPEC countries (and Russia), and by the increases in travel and other economic activity in recent months.

Yet, OPEC’s ability to stick to oil production cuts are in large part unpredictable, due in large part to continued arguments among OPEC countries about market share.[9]

It should be noted that since July 10, 2020 the number of oil rigs in production, in the United States and Canada, increased from 287 to 616.[10] Furthermore, the number of crews finishing off previously drilled wells in the United States has increased this year from 70 to 234, indicating more oil production is posed to come online.[11]

The U.S. Energy Information Administration stated on July 6, 2021: "We expect rising production will reduce the persistent global oil inventory draws that have occurred for much of the past year and keep prices similar to current levels, averaging $72 per barrel during the second half of 2021.” For 2022, EIA said it expects growth in production from OPEC+ and U.S. tight oil production, along with other supply additions, will outpace growth in global oil consumption and contribute to declining oil prices.[12]

Is the Recent Surge in Inflation “Transitory” or “Embedded”?

To summarize the prior section, car prices – which have contributed one-third of the rise in the Consumer Price Index (year-over-year) as of June 2021 (per BLS), will likely decline over the next couple of years. The “supply shock” cause of increased car prices (driven in part by a shortage of consumer chips) is temporary in nature.

Oil prices are largely unpredictable, due to OPEC politics, but increased production in the U.S. and Canada may lead to greater increases in oil production than increases in demand over the next year or so. (Source: U.S. Energy Information Administration, This Week in Petroleum, July 8, 2021.) OPEC may, however, further cut production. Or, at time OPEC countries may diverge due to disagreements on market share, and OPEC countries might increase production when OPEC nations fail to reach consensus.

Housing prices may be in a “bubble” in some markets, at present, as the cost of housing exceeds the reasonable cost of construction in many suburban areas. While housing prices may well continue to rise for another year or more, at some point new home construction will likely catch up with demand, resulting in a lowering of home prices. Housing rental rates will likely increase over the next year, as they are affected by housing prices, but may stabilize thereafter.

If we were to stop there, we might assume that the rate of inflation seen in 2021 – now at 5.4% year-over-year – might fall in future months, and certainly the rate of inflation would appear destined to fall in 2022. In part this is because depressed pandemic levels from a year ago translate to artificially higher year-over-year rates, but that explanation is less sufficient for June. While the base effect hasn’t entirely faded, it is diminishing. Also, stripping out volatile items like food and energy, “core” CPI rose only 4.5% year-over-year in June 2021.[13]

However, economists, as well as those undertaking policy decisions at the Federal Reserve are engaged in a fierce debate about the risk of runaway consumer prices fueled by ultra-accommodative fiscal and monetary policy. In other words, vast government spending, combined with low short-term interest rates (influenced by the Federal Reserve) and purchases of fixed income securities by the Federal Reserve (which has the effect of introducing more cash into the banking system – resulting in money supply growth).

Hence, an even deeper dive is warranted, to even attempt to answer the question – is higher inflation in our future.

Money Supply, the Velocity of Money, and Inflation

According to traditional economic theory, money supply growth and inflation are inexorably linked. As seen in the following chart from the Federal Bank of St. Louis, money supply (as represented by M2 Money Stock) has substantially increased since the pandemic began:


 The "M2 Money Supply," also referred to as "M2 Money Stock," is a measure of the amount of currency in circulation. M2 includes M1 (physical cash and checkable deposits) as well as "less liquid money," such as saving bank accounts and money market mutual funds.

Yet, the “velocity” of money – the rate at which money changes hands (typically measured over a one-year period) has declined substantially over the past twenty years, as seen in this chart from the Federal Reserve Bank of St. Louis (showing money velocity from 1959 through 2020):


The velocity of money in the United States is calculated by dividing the nation’s economic output, nominal GDP — GDP not adjusted for inflation — by the money supply. When the velocity of money is high, a dollar is changing hands frequently to purchase goods and services — suggesting that the economy is doing well. It reflects high demand, which generates more economic activity. When the velocity of money is low, a dollar is not changing hands often to buy things — meaning that economic activity is sluggish. Instead, it is being saved and invested.

To get sustained inflation, we will likely need a pickup in the velocity of money. In other words, we need banks to hold less in their reserves, and to loan out that money to businesses and consumers (which is largely not occurring today, relative to the amount of cash available. And we need consumers to spend their savings (which is occurring, to a degree).

So, to summarize – a huge increase in the supply of money is inflationary, but not so much if the velocity of money has declined (as it did, substantially, from March 2020 to today). Whether the velocity of money will substantially increase is unknown, as it is affected by many factors, although I believe a slight pick-up in money velocity in the second half of 2021 is likely. This, in turn, would tend to favor higher inflation.

But inflation is driven by many other factors, other than just money supply and the velocity of money (which many economists and investors have focused upon).

The Potential for a Wage-Price Spiral

In my personal opinion, while the large money supply and the potential for higher interest rates (and increases in the velocity of money) are a substantial concern, the largest inflation threat comes from the potential of a wage-price spiral – which would in turn trigger higher interest rates.

Wages across the United States are increasing – often dramatically.

When wages rise steadily and consistently over time, those higher earnings don’t trigger sharp inflation. But sudden and dramatic economy-wide wage increases certainly can. That kind of fast nationwide pay raise usually comes from one of two economic drivers — a hike in the minimum wage or a dramatic reduction in the supply of labor.

As reported in NFIB’s monthly jobs report, 46% of owners reported job openings that could not be filled, a decrease of two points from May but still historically high and above the 48-historical average of 22%.[14]

Many companies big and small are increasing compensation, but even that has not been enough to do the trick. This year a record number of firms raised wages and benefits in an effort to lure new hires and to retain valued employees. Large businesses voluntarily increasing their wages include Target ($15 per hour), Hobby Lobby ($17 per hour), Starbucks (10% increase in all wages), Costco ($16 per hour), Walmart ($13 to $19 per hour for workers, with half of company’s employees making $15/hour or more), McDonald’s 650 corporate locations ($11 to $17/hour for entry-level crew), and Amazon $15 per hour). A recent study found that Amazon’s pay raise resulted in a 4.7% increase in the average hourly wage among other employers in the same labor market (commuting zone).[15]

A net 39% (seasonally adjusted) of small businesses reported raising compensation, a record high. A net 26% of small businesses plan to raise compensation in the next three months.[16]

Wage increases are not just voluntarily undertaken by companies. Many states and localities have enacted minimum wages which are far above the federal minimum wage of $7.25, as seen in this recent map produced by Workest:


To help offset the higher cost of supplies and labor, a net 47% of small business said they raised prices in June — the highest reading in 40 years. [17]

The question remains, however, as to whether the higher wages recently seen, which have led (and will lead) to increases in the prices of goods and services, will then trigger further wage increases. In other words, as the prices of goods increases, will workers demand even higher wages – which will then trigger higher price increases – which then trigger higher prices – etc.

And that is the great unknown. Still, I personally estimate a 25% chance of wage-price inflation becoming “embedded” in the economy, and persisting until fiscal and monetary policy changes (higher interest rates, lowering the supply of money, reduced federal spending, etc.) bring such a wage-price cycle under control.

On the Many (Other) Factors Affecting Inflation

The uncertainty about inflation occurs because inflation is driven by many different factors, not just those discussed above.

Several longer-term trends and near-term developments are supportive of higher rates of inflation:

·       A decrease in “globalization” may occur. The import of low-cost goods has tampered inflation over the past 30 years. Core prices for goods rose just 18% between 1990 and 2019, while prices for core services (produced domestically) rose 147% over that time period.[18] However, will trade wars erupt (including less imports from China)?

·       The labor force is not expanding as rapidly, and in some areas is shrinking, due to the decline in the number of working-age adults in many countries. According to a United Nations report, U.S. working-age population growth will slow to just 0.2% a year between 20202 and 2030, down from 0.6% in the decade earlier. (Increased immigration, if permitted, could offset some of the labor shortages projected, especially among skilled workers.)

·       Another trend favoring a higher rate of inflation is the large fiscal stimulus that may occur via direct-to-consumer payments (expansion of the child tax credit, for example) and increases in government spending (whether on infrastructure, renewable energy incentives, or otherwise). On July 13, 2021, leading U.S. Senate Democrats agreed on a $3.5 trillion spending plan, that will form the basis of the reconciliation package (that can be enacted without Republican support, later this year, if all Democrats support the final package).

Yet, there are forces present which would tend to lower inflation, and even lead to deflation, such as:

·       An increase in productivity can be an inflation-killer. Due to investments made by companies during the pandemic in information technology and robotics, productivity on a year-over-year basis is at its highest point in a decade. From the second quarter of 2020 to the first quarter of 2021, labor productivity in the nonfinancial corporate sector jumped 5.3% while hourly compensation rose 2.0%.[19]

·       The concentration of wealth, now at its highest since World War II,[20] can result in less consumer spending. Those who have amassed more wealth possess a far lower marginal propensity to consume, when they receive additional income, than those who are far less wealthy. However, with strong indications that the U.S. equity markets (overall), bond markets, and real estate markets are all overpriced, a downward correction in prices would mitigate some of the wealth inequality seen.

·       Commodity prices have already surged, and projections of commodity prices going forward (particularly food, energy) indicate the potential for lower prices. Commodity price increases appear to have driven in part by supply-side constraints, which tend to correct over time. (However, there is always a great deal of uncertainty about commodity prices, especially in the near term.) Also, by 2025-2030 peak demand for oil might occur, due in large part to the continued deployment of solar, wind, and other renewable energy sources, and the rapid decline in the sale of gas-fueled vehicles expected from 2025 through 2035.[21]

·       The chief problem facing most of the world's developed economies today is the level of outstanding debt, both private and public. Whilst the creation of debt can represent an expansion in the broad money supply, the destruction of debt conversely equates to a contraction in the money supply. As all debts must eventually be repaid, debt by nature is deflationary over time.

In conclusion, while much of the rise in recent wages and prices appears to be one-time adjustments, there is the possibility of sustained inflation over the next few years. While the Federal Reserve has stated that it has the tools to constrain inflation should it continue, there is a fear that the Federal Reserve is over-confident in its own abilities, given the historical difficulties seen in bringing past wage-price spirals under control.

Inflation and Your Investment Portfolio

If inflation does continue for a few years (or longer), what does it mean for your investment portfolio?

Traditionally, commodities have been an inflation edge. But, increases in commodity prices have already occurred, as noted above.

Another hedge against inflation has been real estate. Yet, home prices appear to be in a “bubble,” and office vacancies continue in large numbers. Vacancy rates for industrial properties, such as warehouses, are already quite low, with rents for industrial buildings already rising 7.1% in the first quarter of this year from a year prior.[22]

Should interest rates increase, the valuations of growth stocks will be put under pressure. Value stocks, while not an inflation hedge, will likely perform well relative to growth stocks, although value stocks are not necessarily an inflation hedge.

The following investment strategies, in particular, from ARGI may perform well in a higher inflation environment, should it occur (and should also perform well, relative to the market, due to overvaluations in U.S. large cap growth stocks, as will be discussed in a future edition of Da Bear’s Perspectives):

            Dividend Select Portfolio

Defensive Equity Portfolio

Factor 15 Small Cap Portfolio

Note that higher interest rates, often used to combat inflation, can result in lower returns for growth stocks (as a broad asset class), in part because future earnings of growth stocks are subjected to a higher discount rate under traditional stock valuation methodologies. All of the above ARGI investment strategies employ investment “factors” that tend to tilt away from growth stocks, to some degree.

Over the very, very long term, stock prices often adjust with inflation. This is because, as prices increase, so do corporate revenues, which in turn ultimately drive higher earnings. However, as evidenced by the performance of the U.S. stock market in the 1970’s, the overall valuation of stocks can be driven substantially lower should inflation, and interest rates, rise dramatically. In combatting inflation via higher interest rates, bond investments are made more attractive to investors, and equities (stocks) less attractive, leading to potential undervaluation in stocks (relative to norms).

Long-term bonds would likely fare poorly should inflation surge, as interest rates would also likely rise. (Bond prices fall when bond yields rise.) Short-duration bond portfolios are likely to perform better. A bond ladder, observant to making proper investments given the present yield curve, is also a good strategy for the long-term, regardless of inflation.

Inflation-adjusted bonds would appear at first to be a wise choice. Treasury inflation-protected securities (TIPS) and I-bonds are issued and backed by the U.S. government. However, TIPS operate a bit differently than traditional U.S. Treasury bonds. Investors receive regular interest payments based on the face value of the bond until it matures. Investors also receive inflation protection, via a yearly adjusted par value that derives from CPI-U, the U.S. government’s primary measure of inflation. This changing yearly value is intended to maintain the TIPS’ purchasing power over time. However, recent demand for TIPS, which are now issued in 5-, 10-, and 30-year terms, has been quite strong; as a result, TIPS’ yields are currently negative, with investors betting that TIPS’ future inflation payments will make holding them worthwhile. Still, a shorter-duration TIPS bond ETF may form part of a portfolio, and provide some protection against possible future higher inflation.

Timing the market is difficult, as is predicting future inflation. Hence, any adjustments in your investment portfolio should ordinarily be undertaken using a longer-term view, and considering the consequences if inflation increases or remains low.

Until the next time …

Very truly yours,

Ron (Da Bear)

Email: bear@argi.net

Dr. Ron A. Rhoades serves as Director of the Personal Financial Planning Program at Western Kentucky University, where he is a professor of finance within its Gordon Ford College of Business.

Called “Dr. Bear” by his students, Dr. Rhoades is also a financial advisor at ARGI Investment Services, LLC, a registered investment advisory firm headquartered in Louisville, KY, and serving clients throughout most of the United States.

The author of the forthcoming book, How to Select a Great Financial Advisor, and numerous other books and articles, he can be reached via: bear@argi.net


[1] KFF analysis of National Health Care Expenditure (NHE)_ date Personal Consumption Price Index (PCE) from Bureau of Economic Analysis

[2] U.S. Bureau of Labor Statistics

[3] Scott Horsley, “Inflation Is Still High. Used Car Prices Could Help Explain What Happens Next.” NPR (July 13, 2021).

[4] U.S. Bureau of Labor Statistics

[5] Tim Levin, “Why used cars are so expensive now — and when prices may drop,” Business Insider, July 12, 2021.)

[6] National Association of Realtors, U.S. Economic Outlook: May 2021

[7] CoreLogic U.S. Home Price Insights, July 6, 2021

[8] CoreLogic, June 15, 2021 release

[9] BOE Report, “OPEC+ impasse risks price war as demand surges, says IEA”

[10] Baker Hughes Rig Count Overview

[11] Julianne Geiger, U.S. Rig Count Rises in Volatile Week for Oil, oilprice.com (July 9, 2021), citing the Frac Spread Count provided by Primary Vision.

[12] Devika Krishna Kumar, “U.S. 2021 crude output to decline less than previously forecast, EIA says,” Reuters, July 7, 2021

[13] U.S. Bureau of Labor Statistics

[14] National Federation of Independent Business, which represents small businesses in the U.S., monthly jobs report

[15] Derenoncourt, Ellora and Noelke, Clemens and Weil, David, Spillover Effects from Voluntary Employer Minimum Wages (February 28, 2021)

[16] National Federation of Independent Business, monthly jobs report

[17] National Federation of Independent Business, which represents small businesses in the U.S., July 13, 2021 release

[18] The Wall Street Journal, July 12, 2021

[19] Gary Shilling, “How Labor Shortages Help Profits and Hurt Inflation,” Bloomberg (July 1, 2021)

[20] Ray Dalio, Bridgewater Associates

[21] Noah Browning, “Factbox: Pandemic brings forward predictions for peak oil demand,” Reuter (April 21, 2021)

[22] CBRE U.S. Industrial and Logistics Figures Q1 2021