Inflation Horizon

November 04, 2021

I am thrilled to be discussing inflation. Not that inflation is a particularly exciting topic, rather I’m just glad to discuss anything but COVID 19 in this blog!  As we cautiously start thinking forward to a post-Covid world, we at New England Capital have the opportunity and responsibility to worry about more normal economic and financial concerns. The current inflation rate is 5.4% and the Social Security Administration is set to increase the cost-of-living adjustment by 5.9% in January 2022.

Inflation is the general rise in the prices of goods and services in the economy. Inflation acts as a tax on the consumer by having us pay more for the same product or service. We see inflation at the grocery store and the gas pump. You certainly would have noticed higher prices if you purchased a new or used car or bought or sold a house recently. I remember my economics professor at UConn sharing with us that inflation is caused by too many dollars chasing too few goods and services. 

That is exactly what we have today. For most Americans, but not all, we have been saving more money than usual. According to the Kansas City Federal Reserve Bank our personal saving rate in the US increased from 7.2% in December 2019 (pre-Covid) to a record high of 33.7% in April 2020.  Instead of saving $7.20 for every $100 in income we were saving almost $34 of every $100.  Since hitting this historic high, the rate has slipped back to 14% but that’s still double what we were saving in pre-Covid. 

Several factors could explain this large increase in our desire to save:

  1. Consumers always save more in recessionary times. We become more cautious amid uncertainty and hence more reluctant to spend.
  2. Large transfer payments from the Government, including stimulus checks and enhanced unemployment benefits boosted incomes.
  3. There were very few places to spend money when the economy was closed!

This explains the “too many dollars”.  Why the “too few goods and services”?  Supply chain disruptions have been a major cause.  In the 1980s the Japanese introduced the concept of “just in time inventory”.  Don’t produce more parts than you need to for immediate production.  The world got very good at this.  The world also became more interdependent.  This means where products are designed can be different from where parts are manufactured, which can be different from where the parts are assembled, which can be different from where the final product is wholesaled, retailed, and ultimately consumed. There are few problems when you don’t have a worldwide pandemic, but there’s a lot of places and a lot of ways for bottlenecks to develop when you do.

Labor or human capital was also disrupted during the pandemic. The US unemployment rate which was 3.8% in February 2020 (pre-Covid), soared to 14.4% in April 2020.  According to the US Bureau of Labor Statistics, the current unemployment rate is 4.8%.  So as more people are back to work, there’s built-up demand to spend money with a lower supply of goods and services.  That is the recipe for inflation.

We have been living through a grand experiment.  We have never in history, shut down the economy, put it on artificial life support and attempted to revive it before now. The question is no longer if we’ll have inflation; it’s how high will it go and how long will it last?

Benjamin Bernanke, the former Chairman of the Federal Reserve from 2006-2014, was a keynote speaker at an advisor industry conference last week.  The good news is Mr. Bernanke sees inflation moderating in 2022.  He expects 5-6% US economic growth this year, slowing to 3% next year. At the same time, he sees full employment in the US by next fall.  The Federal Reserve has succeeded in getting inflation higher, maybe even higher than it wanted, according to Bernanke.  Yes, the Federal Reserve wanted inflation because deflation scares them more than inflation.  They have more tools to beat back inflation than they do to prop up deflation.  In other words, depressions are much more troublesome than recession.  He also feels that “Stagflation” (rising prices and stagnant growth) is unlikely because we are still seeing strong growth.  (See the graph below.  Source: International Monetary Fund/Bloomberg)

According to the Wall Street Journal the current Federal Reserve Chairman, Jerome Powell said on Friday, October 22, 2021, “I do not think it is time to taper, I don’t think it’s time to raise rates”. Tapering is the process of slowly pulling back the stimulus they’ve been providing during the pandemic, or in my words, taking away the punchbowl before the party gets out of hand! Mr Powell ended his remarks by stating “no one should doubt that we will use our tools to guide inflation back down to 2% if it looked like more persistent inflationary pressures were taking root.

We at New England Capital believe that the US will not return to a 1970s style of Stagflation since we’re still projecting economic growth. You need both rising prices and no economic growth for stagflation to occur.   We will continue to monitor the economic and market conditions for you.  We have been proactive this past week by making some changes to the bond part of your portfolio by shortening the length of our bonds and adding TIPS or Treasury Inflation Protected Securities to portfolios where we thought appropriate.  Of course, we will continue to watch your accounts and monitor the economy and the market on your behalf.

By the way, I am just as concerned with “shadow inflation”.  That’s when prices remain the same but the quality or quantity of something has been reduced.  If you’ve ever opened a bag of chips and thought there’s less chips in the bag or bought what your thought was the same candy bar only to feel the bar was smaller, you know what I’m talking about. With Halloween coming up, I also have a problem with “fun” size candy bars.  A fun size candy bar should be the size of a microwave.  But I think that’s a topic for a future blog.

I hope you and your family are well and please stay safe.