It’s likely that you have all felt a pinch to your wallet over the past year. From groceries and gas to cars and vacation rentals, the cost of everything is up, and not just a little bit. Back in December, the Dollar Tree announced it’s raising it’s prices for the first time in 35 years. This inflationary burst has us all wondering if these higher prices are here to stay.
According to the Bureau of Labor Statistics, from December 2020 to December 2021, consumer prices for all items rose 7%, the largest December to December percent change since 1981. Here some of the categories with the largest percent increase in 2021:
• Gas – 49.6%
• Used cars and trucks – 37.3%
• Rental cars – 36%
• Hotels – 27.6%
• Furniture – 17.3%
• Meat, poultry, fish and eggs – 12.5%
• New vehicles – 11.8%
I know I personally have noticed all of the above, especially when it comes to planning vacations. I even learned that the government has increased the cost to renew passports from $110 to $130 last month. That being said, when looking at the 1 year change in inflation, it’s important to keep in mind that 12 months ago, much of our economy was shut down and people bought less things and traveled less. We were in a deflationary position back then. Fast-forward to now, the inflation hike we are experiencing is being driven by a combination of supply disruptions, higher demand and more dollars in circulation.
On the supply side, Covid has caused factories to shut down, worker shortages and shipping bottlenecks among other things. This leads to not only a shortage of products, but also delays in unloading and distributing the products that do arrive. But the pandemic is not the only issue affecting supply in 2021. There have been other events that have compounded the problems. One example is the Texas winter storm in February of last year. This storm came without warning and shut down production of many petroleum-based products that play into multiple industries from PVC pipes to car bumpers. Texas is home to about ¾ of basic U.S. chemical production capacity. Several oil refineries shut down, leading to the largest reduction in Gulf Coast refinery operations since Hurricane Harvey in 2017.
On the demand side, many consumers have reduced their debt and built-up savings due to months of lockdowns and repeated rounds of government stimulus checks. There are a lot of people with pent-up demand wanting to get back to having fun. The labor shortage has also led to much higher wages. According to the Bureau of Labor Statistics, wages in the U.S. increased 5 percent in 2021 alone. The desire and ability to spend meant that consumer activity has been robust even as costs rise. So now we have the classic example of too many dollars (demand) chasing too few goods (supply).
There are some reasons to believe this rapid inflation is temporary, but define “temporary”. The past 2 years have shown us just how interconnected we are to the rest of the world. How well our country handles Covid depends on how the world controls it as well.
The shortage of goods should ease as supply chain issues are ironed out. We also seem to be at the end of the government stimulus checks so that could curb spending some. To combat inflation, the Fed also has announced plans to withdraw its monetary stimulus and raise rates. At the committee meeting last week, the Fed signaled that they are on track for an interest rate hike in March. This will be the first rate increase in 3 years. The real challenge will be unwinding the Fed’s massive bond portfolio and slowing the growth of the dollar driven by the government’s deficits.
Navigating to the ideal amount of inflation is tricky. We are all concerned about the seemingly hyperinflation of the past year, but very low inflation can be problematic as well. Deflation is associated with weak economic conditions and along with lower prices come lower wages as well. We have managed almost a decade of inflation below the Fed’s 2% inflation target. Two big contributors to this have been technological progress and globalization. Technological advancement has brought down the price of goods tremendously by increasing labor productivity. For a decade we have increasingly exported our inflation to other countries through trade. Shifting manufacturing overseas has kept our prices lower and pushed production cost increases abroad. The one thing COVID has exposed is our reliance on foreign manufacturers. There is now a push to repatriate some of that capacity. It’ll be interesting to see what the price impact will be on those items.
Economic activity and employment indicators have continued to strengthen so it is a good time for the Fed to begin making their move. As they step in to try to get back towards their 2% inflation goal, they must find the balance of cooling off the economy without leading us to a recession. The problem is this will be a multiyear effort and the Fed has historically been a step or two behind the real economy which leads to bubbles. One might even say our current situation is an example of this. The pure size of these interventions often whipsaws the economy. Growth impacts earnings and earnings drive stocks. It will be a headwind for stocks, but in the long run this is necessary and worth the short-term pain.