Across most of the world since the early 1980s, albeit with some hiccups, investors have seen a general decline in both the average level of inflation and the volatility of inflation.



Five-Year Annualized Average Inflation

Five-Year Annualized Volatility of Inflation

Inflation is a general increase in the price level. It’s not the increase in just one or two prices, which is a change in relative prices, but an increase in all prices. In practice, though, inflation isn’t an actual increase in literally every single price. Rather, inflation is an increase in some price index, which is a weighted average of many prices. In the U.S., a common price index to measure inflation is the CPI. The CPI measures the changing cost of purchasing a fixed basket of goods and services. When serving sizes or quality changes, the government statisticians make what are called “hedonic adjustments” to account for what would otherwise be hidden forms of inflation.

The U.S.’s central bank, the Federal Reserve (Fed), officially targets inflation based on a different price index: the Personal Consumption Expenditures (PCE) Price Index. Unlike the CPI, which is based on a fixed basket of goods and services that’s only periodically updated, the PCE Price Index is based on a basket of goods and services that’s updated as households change their purchases over time.

If inflation meant that all prices increase, that would be a high bar to clear. The chart below shows the long-term history of the PCE Price Index for three categories of spending: durable goods (items expected to last three years or longer), nondurables (items expected to be consumed immediately or with a short shelf life), and services (including housing).

During much of the 1960s through early 1980s, the PCE Price Index results for all of these categories were on an upswing, so there did appear to be general inflation. In 1980, the slopes changed, showing a lowering of inflation. Toward the end of the 1990s, durable goods prices began generally declining. Since the end of 1999 and through the third quarter of 2021, durable goods prices have fallen 18%. However, nondurable goods prices have increased 53% and services prices have increased 76%. Thus, inflation as we observe it in practice is really an amalgam of prices changing where the weighted average is positive.

Cumulative Inflation

To see the history of sources of inflation, it’s easier to look at year-over-year percentage changes in the PCE Price Index for each category. The spikes in the PCE measure for nondurables inflation correspond to spikes in oil prices and sometimes to increases in food prices. The unusual thing about the COVID-19 crisis is that the long period of deflation in durable goods prices suddenly came to an end, as can be seen by the rapid rise in the PCE durables inflation numbers. A critical question looking forward is whether that change is a blip to be reversed or an actual change in the trend. As we explain below, we think it’s not quite a blip, but not quite a change in trend.

Year-Over-Year Inflation

Over shorter horizons, many shocks can hit the economy’s demand side and supply side to cause short-term variations in prices. Sometimes these shocks can be self-correcting with short-lived effects, but sometimes shocks can leave scars. Many investors today may fear that the COVID-19 crisis—with its extraordinary fiscal and monetary response—may count more as a shock that leaves a scar than a shock that’s short-lived.

The shock can be seen in the spending on different categories of goods and services. The typical U.S. household had been increasing its share of spending on services, which reached 69% by the end of 2019. By the second quarter of 2021, though, services comprised only 64% of spending—a large drop. Spending on durables rose from 10% to 12%, and nondurables spending increased from 20% to 22%. Supply chains were strained to handle the surge.

With everyone very aware of the supply-chain problems, it probably became easier for businesses across the board to justify price increases than it would’ve been if the problems had been more isolated to particular parts of the economy.

The idea of short-lived inflation being caused by COVID-19 is easy to lampoon. Fed Chair Powell originally said inflation would be “transitory,” but there was no real agreement about what transitory meant. We originally said transitory meant lasting 12 to 18 months. That means we believe we should be back toward more “normal” inflation levels by September 2022, with the inflationary path turning toward normal around the end of the first quarter or the beginning of the second quarter of 2022.

There’s a risk that extraordinary policies become the ordinary course of events, but we believe that’s a low risk. Some major central banks are already starting to taper their asset purchases. Fiscal deficits ballooned during COVID-19, but they look to be set to shrink as pandemic support comes to an end. The money supply—for example, a broad measure of money in the U.S. known as M2—grew nearly 40% over the two years from the end of the third quarter of 2019 through the end of the third quarter of 2021. However, the Fed is slowing the growth of its balance sheet and may let securities run off its balance during 2022, shrinking the money supply.

The return of ordinary fiscal and monetary policy should help inflationary pressures abate over the longer term. Central banks have altered their operating frameworks to allow for more “inflation overshooting” to make it clear that their inflation targets (generally 2%) were supposed to be thought of as averages, not maximums. That change could push the level of inflation up slightly higher and cause more volatility around the trend level of inflation.

In the nearer term, unwinding the pressures that caused the jump in many prices will be critical. When the government issued debt to fund aid to households and businesses, it took future purchasing power (investors’ savings) and brought it into the present. The creation of immediate purchasing power hit a wall: There was a dearth of things to purchase because many businesses had shut down and supply chains weren’t up to the task. The supply strains should subside over time because businesses have a strong profit motive to figure things out.

There’s a risk to our outlook: Costs to businesses could increase if they try to build more resilient supply chains. Starting with the trade wars between the U.S. and China in 2016, there was a lot of talk about deglobalization and reshoring production. While it’s possible that trend could continue, we believe it’s premature to conclude that costs would go up.

What matters is productivity—not just costs. Further, it’s premature to conclude that cost increases will result in higher consumer prices instead of tighter profit margins. To the extent that cost increases eat into profit margins, companies can adjust their operating and financial leverage. Overall, though, deglobalization is something to watch for as a possible risk to the longer-term inflation outlook.

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