Where is Inflation Headed?

July 15, 2021

Inflation is on the rise-big time.  June’s Consumer-Price-Index increased 5.4% from a year ago- the highest 12 month rate since August 2008. Prices for used cars and trucks went up 10% in one month, primarily due to a shortage of vehicles.  Airline fares, rental cars, entertainment costs and recreation are rising sharply.

However, America’s economy is booming- the most of any developed country in the world. U.S. gross domestic product (“GDP”) rose 6.4% in 1Q21. It’s expected to grow 9.1% in 2Q21.  Of course, the base is 2020’s GDP, which was decimated by COVID.

Vaccinations have played a huge role in the turnaround. Across the world, less than 10% of people have been vaccinated; in the U.S. we are at 50%.  This has given customers and workers the confidence to leave their homes and go to work, go to restaurants, do outdoor activities, travel and create tremendous demand for goods and services. COVID-era business restrictions have recently ended or have been reduced. At the same time, there has been trillions of dollars of federal pandemic relief which has resulted in huge household savings now being spent. Businesses are adding people and paying higher wages. Shortages between demand and supply have pushed up prices.  Lastly, consumer expectations for higher inflation can affect economic decisions in households. These factors are all driving inflation.

As to what to expect in the future, it’s important to look at the main trends causing inflation now.  This week, the WSJ nicely recapped the four main trends causing inflation:

  1. Return to Pre-Pandemic Levels. Airfares and hotel prices collapsed with COVID. Those flying or staying in hotels, even a few months ago, were paying almost nothing. Now, compared to last year, airfares are up 25% and hotels 17%.  Even so, current prices are still below their 2019 levels.
  2. Supply Constraints. Manufacturers are increasing production.  Shortages in new cars, brought on by shortages in computer chips, resulted in shortages of used cars.  Prices rose in all categories.  New cars are now 5% above 2019 prices, while used cars are up 41%- an increase that is expected to moderate. In addition, shipping goods from China to the U.S. is now 4X as expensive as pre-COVID. Another example is broken supply chains due to many companies carrying lower inventory levels during COVID and not ready for the quick turnaround in demand.
  3. Permanently Higher Prices. Restaurant prices went up 4% in June.  Customers are back at restaurants but the workers aren’t.  Many of the former hospitality workers have changed careers; in many cases increasing their pay.  Further, restaurants are paying higher wages and are still understaffed.  Because of generally thin margins, restaurants need to pass along wage increases and it is possible that increases in prices for restaurants and some other sectors will remain higher.
  4. Slower Price Increases-For Now. As of April, American homes were up in price by 14% over the prior year.  Generally, rents increase in response to housing increases.  They haven’t yet.  Rents on a primary home in June were up 2% from the previous year.  Before the pandemic, rents were increasing 4% per year.  Historically, it takes 18 months for increases in house prices to be seen in rents. Rents should increase as well as other areas.

Last week, the Federal Reserve’s report indicated that inflation had risen because of “bottlenecks, hiring difficulties and other largely transitory factors.”  Most Federal Reserve officials believe that inflation will remain around 2% over the next two years. They don’t expect to increase rates until 2023.

Many economists don’t agree. The WSJ reported last Sunday that “Americans should brace themselves for several years of higher inflation.”  This was based on surveys of economists whose responses showed an average increase of inflation of 2.58% per year from 2021 through 2023.  Frankly, that wouldn’t be so bad.

Here’s why. The Economist last weekend provided an update on inflation entitled “Boom and Doom.”  It provided the downsides of sustained inflation. First, inflation hurts both on a personal basis (purchases cost more which decreases happiness) and economically, because central banks (like the Fed) have to slow the economy or engineer a recession. Second, sustained inflation has the potential to severely disrupt asset markets. Current values for stocks, bonds and even houses are based on the assumption that interest rates will stay low for a long time.  With sustained interest spikes, asset values can change significantly.  On the plus side, inflation is created by sufficient economic growth, which is what we all want.

America is seeing higher inflation than anywhere else in the world because our economy has come roaring back.  This is better than it was in the 2010s (after the 2008-2009 Great Depression) when policymakers at developed countries couldn’t get inflation back to 2% and overall economic growth (GDP) suffered.

The WSJ listing of the four key trends above provides a good way to look at where inflation may be headed. Inflation trends caused by (1) return to pre-pandemic levels and (2) supply constraints should level out.  There will likely be some (3) permanently higher prices and (4) there will likely be some areas, such as rents, not increasing now but are likely to in the future.  If the Fed can continue to try to stay close to 2% inflation or maybe a little above it, our economy should do quite well.

The Economist concludes its article with the following: “America has demonstrated that a remarkable combination of fiscal and monetary stimulus can cause prices to accelerate even when interest rates are stuck at rock-bottom. The challenge now is to make sure that the price paid for it in terms of spiraling prices does not rise too high.”

So far, Washington has done a very good job for us and America. Our turnaround after COVID is happening. That makes us happy in many ways. Let’s hope it continues.

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