Editor’s Note: This article was originally published in the 2021 Economic Outlook section of Record-Eagle. For more stories, click here to read the entire section online.
What could possibly go wrong? The US economy continues to reopen with enough leeway to continue growing, as employment and industrial capacity remain well below pre-pandemic peaks.
Unable to spend during shutdowns and receiving government cash transfers, the US consumer has over $ 2 trillion in cash surpluses that are expected to continue to support economic growth as the US Federal Reserve maintains unprecedented policy easy money and growth. As vaccination rates around the world continue to improve, even variants of COVID-19 do not appear likely to disrupt positive economic dynamics.
Our main concern is inflation – the widespread rise in the cost of goods and services without a corresponding increase in value. It’s no secret that inflation has been evident in recent months. The real debate is not whether we have seen inflation over the past year, but whether it will persist in the future.
Readers of a certain age will recall that persistently high levels of inflation in the 1970s were associated with difficult economic times. Inflation, when added to the unemployment rate, has been famously summed up as the “misery index” by economist Arthur Okun.
In the modern interpretation of this measure, “misery” peaked in June 1980 when the consumer price index recorded inflation for the previous year at 14.3%. Inflation produces misery in many ways. For consumers, this means their hard-earned dollars aren’t buying as many goods and services, so actual consumption slows – or could even decline. For businesses, inflation creates new risks and challenges for profitability. For investors, inflation usually means poor performance of the bond portfolio and a tough time for equity investors.
This cycle, our particular concern is the impact that inflation could have on the policies of the Federal Reserve Bank.
In 2020, the Fed chose to try a new approach, operating within a new monetary policy framework that explicitly leaves more room for inflation. Although it may seem rather obscure, the new monetary policy framework is a radical departure from past policies. For a central bank that has had to balance its dual mandates of price stability and full employment, this represents a shift in the balance towards employment.
Federal Reserve leaders, including Fed Chairman Jerome Powell, observed the recent rise in inflation and declared it “transient.” This does not mean that the recent price hike will reverse, but rather that the Fed will reduce the rate of price hikes to levels more in line with inflation that the central bank deems acceptable. While these levels have never been fully defined, the Fed’s willingness to accept inflation above 2% for an “extended period” probably means between 2% and 3% for that period.
We largely agree with the âtransitionalâ view of inflation. However, we do note a few caveats that suggest the Fed is underestimating the durability of the forces that have been unleashed:
- 1) Commodity prices: It is true that high prices generate new supply, but this assumes that there are no obstacles to the required investment. Regulatory uncertainty in the energy sector may be an example of the type of barrier to new production that keeps prices on an uptrend. The pandemic has rapidly changed the way people work, live, travel and spend in ways that create dead ends that are not resolved quickly.
- 2) Slack: While we’re especially hopeful that U.S. companies will attract workers to the sidelines, a demographic analysis has suggested there may be fewer readily available workers than the Fed realizes. We expect tight labor markets in the long run which will put upward pressure on wages. Unless they are offset by productivity gains, higher compensation costs are a key driver of inflation.
- 3) Expectations: Fed Chairman Powell regularly refers to inflation expectations as being well âanchoredâ. So, yes, inflation expectations remain low, but we believe that could change faster than Fed policy could adjust.
We have witnessed a decades-long period of low inflation driven by globalization, the rapid adoption of technology and the aging of the world’s population. These forces are still in place, but arguably with less impact than in previous years.
Our belief is that inflation will moderate from the recent peak, but may surprise the Fed by staying slightly higher for longer. In other words, inflation is “transient”. With long-term disinflationary forces still intact, we cannot argue for runaway inflation.
In fact, we are quite optimistic about the ability of the business community to adapt to the challenges of the post-pandemic economy, including workforce challenges.