It seems every year the markets have some economic theme that dominates the news and drives volatility. These themes always vary in topic but are common in that they all relate to big picture issues such as Fed policy, the jobs market, elections, etc. This year the thing on everyone’s mind seems to be inflation.
Now that the economy is largely reopened, GDP is snapping back with surprising speed and the rebound is outpacing the government’s monetary and fiscal policy changes. This is leading to concerns that these highly stimulative measures (both actual and proposed) are going to overheat the economy and, among other things, lead to higher prices. These concerns appear to be well founded as price increases, as measured by CPI, are at the highest levels in over 25 years.
The thing to keep in mind about inflation is that it is in the eye of the beholder. It really depends on what prices you’re measuring since it doesn’t affect everything at once except in extreme circumstances. So when policy makers are evaluating these things, they really try to focus on how significant these changes are to the average household. For example, the average American household spends about 5% of their budget on food. Food prices would have to double before people would really feel the effects of that. Housing and transportation are another matter. Those costs represent a combined 55% of the average household expenses and thus people are far more sensitive to those costs going up. Childcare is another big-ticket item, especially in single-parent households.
What exactly is inflation and what causes it? The textbook definition is that it is the decline of purchasing power of a given currency over time. The easiest way to think of the causes are too many dollars chasing too few goods. Therefore, either an increase in the money supply or a shortage of goods can lead to inflation. Higher money supply generally leads to permanently higher prices and supply shortages usually lead to temporary price increases. Inflation can also be seen as a persistent form of theft. It takes a few percentage points of your wealth away every year. it can also be viewed as a type of tax.
Inflation is also an important consideration when evaluating investment returns. This is where the concept of real returns becomes important. The real return is the return you achieve above the inflation rate. An investment return equal to the inflation rate only means you’re treading water. This is why the performance of the stock market is so important to your long-term financial health. It has provided the best return above inflation of all asset classes. That being said, this also has to be balanced against the short-term uncertainty if you’re needing a steady cash flow to pay your bills every month.
The most dramatic price increases lately have been due to supply chain disruptions from the COVID shutdowns around the globe. As the world has become more integrated, manufacturers have moved away from holding expensive supply inventories and adopted what is referred to as just-in-time manufacturing. This is where they receive their supplies almost immediately as needed. Built into these systems are alternative suppliers should one be unable to ship. These alternative solutions don’t account for something like COVID where the entire supply chain is impacted. The most notable example of this is the chip shortage coming out of Asia that has forced a number of auto plants to close for a lack of chips used in their cars. Then, of course, there’s all the stuff that comes out of China. 2020 taught us a lot about our reliance on China for our day-to-day items.
Thankfully, these disruptions are all temporary. The bigger inflation concern is the issue of too many dollars. The massive deficits and resulting debt has led to an incredible increase in the supply of dollars in circulation. To put this into perspective, three-fourths of U.S. dollars in circulation now didn’t exist ten years ago. The only thing that has made this possible is the fact that there continues to be a huge global demand for U.S. dollars. We have benefited greatly from being the world’s reserve currency, but this is not a sustainable path. At some point the world won’t be able to absorb all this new money. This is something to think about when you hear the word trillion tossed around so lightly in Washington.