The Return of Inflation?

Updated: Jun 8

For those of us who remember the 1970s, you would be forgiven for feeling a twinge of déjà vu in recent weeks. Here in the Southeast U.S., we saw gas shortages and long lines at the pump, albeit due to the very modern problem of a cyberattack by a foreign criminal gang rather than the whims of OPEC. Couple that with headlines trumpeting the return of rising inflation, and you may find yourself unwillingly digging in your closet for those old pair of bellbottoms. While this gas shortage was thankfully short‐lived (after the Colonial Pipeline paid $4.4 million in ransom money to Russian hackers), we can’t be so sure about the staying power of inflation. On the surface, the numbers do look quite alarming – prices for consumer goods, represented by the Consumer Price Index (“CPI”), jumped 0.8% in the month of April, the largest monthly increase in over a decade. On an annual basis, CPI rose 4.2% – the largest 12‐month increase since September 2008.

Inflation, while simple in concept, is actually quite a complicated thing to gauge – its effects can be narrow or widespread, temporary or long‐lasting, a sign of a healthy economy or a cause for concern. In this letter, we will tackle some of the basics, examine the current context of rising prices, discuss the impacts of inflation on an investment portfolio and strategies to mitigate the risk.

Figure 1: Consumer prices have risen far less than the Federal Reserve’s 2% inflation target. Source: Claudia Sahm (March 19, 2021) [Twitter post]

Is inflation always bad? Economists define inflation as the decline in purchasing power of a particular currency. The effect of this can be measured by the rise of prices over time because in an inflationary environment, a fixed amount of dollars will buy less of a given good or service. In other words, inflation simply means that your dollar just doesn’t go as far as it used to. However, some modest inflationary pressure is actually a sign of a healthy economy. Why? Because, theoretically, in a growing economy where there is an increased demand for workers, wages will rise. More money in pockets increases demand for goods and services, causing prices to rise as well. Not factoring in gains in productivity or efficiency, wages and prices should both modestly tick up as the economy expands. In fact, the Federal Reserve’s inflation target is not zero, but 2% annually (to be precise, the Fed targets core inflation, which excludes the more volatile food and energy sectors). In reality, the U.S. economy has consistently run below that level for several decades. As shown in Figure 1, since the Global Financial Crisis, actual inflation has lagged well behind the Fed’s 2% target – a sign of stagnant wages and sluggish economic growth despite periods of historically low unemployment.

Figure 2: The value of CPI from April 2018 – April 2021. Prices in April 2020 collapsed resulting in a high year‐over‐year increase in April 2021, despite a longer downward trend line. Source:

The pandemic and benign inflation. The 4.2% year‐over‐year increase in CPI reported in April was dramatic – over double the Fed’s target rate. But does it signal the beginning of harmful, runaway inflation that will outpace wages and dampen the value of the U.S. dollar? Not necessarily. To start, the past 12+ months have been extraordinary and unprecedented, in both human and economic terms. As COVID‐19 began to spread in March 2020, the economy shut down virtually overnight, closing businesses, disrupting supply chains and grinding manufacturing to a halt. As a result, the prices of goods plummeted across the economy, impacting everything from gasoline, to airline tickets, to women’s dresses (because retailers were forced to offer steep discounts as inventory piled up in un‐trafficked stores). For this reason, the change in CPI from the spring of 2020 to the spring 2021 will be unusually large simply because of depressed prices last year (see Figure 2). Neil Irwin, writing in his January 16 The Upshot column in The New York Times calls this the “yo‐yo effect.” Using women’s dresses as an example, Mr. Irwin points out that on paper, prices are on track to be nearly 18% higher than they were at this time last year – even so, they would still be 9% below their pre‐pandemic levels. In fact, in August 2020, partly in anticipation of the yo‐yo effect, but mostly in recognition of years of persistently low inflation, the Fed reframed its inflation target from 2% annually to a 2% average over the long term, thus allowing for periods of higher inflation in certain economic conditions.

Another pandemic‐related, and potentially temporary, spike in prices can be explained by what Mr. Irwin calls “the end of hibernation.” Like a ravenous bear emerging from a long winter’s nap, the public’s increased appetite to travel, shop in stores and eat out after a year of abstention may cause abnormally high demand. Couple that with decreased supply and the laws of economics dictate an increase in prices. Additionally, retailers may be tempted to raise prices to make up for lost revenues in the pandemic. These effects may not only impact things like rental cars or hotel rooms, but also less obvious things like dress pants as people ditch their sweatpants and return to office life. These kind of price changes, due to typical market forces like supply and demand, are actually a sign of a recovering economy and not necessarily a warning sign of impending runaway inflation.

The risk of too much liquidity. A riskier form of inflation may result from the current glut of accumulated savings. For those fortunate enough to be able shift to remote work and maintain their income level throughout the pandemic, saving money became easier with typical splurges such as dining out or taking vacations off the table. This led to a huge increase in household savings – Americans saved $1.56 trillion more from March through November 2020 than they did over the same period in 2019. And that was before two additional rounds of government payments at the end of 2020 and earlier this year. As such, total U.S. savings on deposit have exploded to nearly $11 trillion (see Figure 3) – if everyone spent that money at once, supply may not meet demand. Unlike the “end of hibernation,” this effect would not only be focused on industries impacted by the pandemic, but would be widespread, pushing prices higher across the economy.

Figure 3: U.S. savings on deposit have sharply increased over the past year. Source: Board of Governors of the Federal Reserve System (US), retrieved from FRED, Federal Reserve Bank of St. Louis

Many economists believe that stimulus is just what is needed following years of stagnant growth and last year’s economic contraction. If the economy can absorb the increased demand through a corresponding increase in supply, rising prices would be offset by more factories, more jobs, and higher wages. However, the danger lies in the risk of starting a self-fulfilling cycle where businesses and consumers start anticipating higher prices – this fuels demand even more as consumers look to buy goods before prices rise further, resulting in higher prices, and so on, and so on. This spiraling cycle, or hyperinflation, can wipe away the positive effects of economic stimulus. In fact, the inflationary environment of the 1970s was preceded in the 1960s by a period similar to today, with increased government spending and a rise in incomes.

Figure 4: The anticipated decline in labor force participation from 2015 ‐ 2030. Source: ILO Statistics

Global inflationary trends. The pandemic and the U.S. government’s reaction have created an environment that risks sparking a liquidity‐fueled period of runaway inflation, but those are not the only dangers. Global macroeconomic trends, some related to the pandemic, some geopolitical, and others demographic, pose longer‐term threats. As mentioned above, the U.S. (along with other developed nations) has experienced a period of low inflation for three decades, marked by muted growth and falling interest rates. Economists are not exactly sure why, but a contributing factor may be the huge influx of cheap global labor, particularly from China, that has tamped down wages in developed economies. This global pool of inexpensive labor is expected to shrink in coming years for a variety of reasons. For one, the growth of China’s more educated middle class has raised wages in the country. Additionally, the legacy of China’s “one child” policy has created a future demographic crisis with a decreasing population that will lack enough working‐age people to sustain the aging majority. Developed economies are seeing similar demographic trends with populations increasingly skewing older. Combine a shrinking working‐age population (see Figure 4) with a shortage of inexpensive labor, and the result may be a world with too few workers, putting upward pressure on wages. Other catalysts for inflation loom as well, such as trends away from globalization (e.g., increased tariffs, populist movements like Brexit, etc.), widespread deficit spending and growing global debt, and a weakening dollar that may no longer hold its place as the world’s reserve currency (see our 2Q2020 letter for more on this topic).