Thoughts on Inflation – October 2021

The United States Bureau of Labor Statistics reports the Consumer Price Index (CPI) monthly and is probably the most widely used gauge of inflation. It takes surveys from people in urban areas and compiles them into a report. But there are different measures for inflation, one that might be more accurate than the CPI is the personal consumption expenditures index (PCE). It is managed by the Department of Commerce’s Bureau of Economic Analysis and measures goods and services bought by all U.S. households as well as data from suppliers. 

There has been a lot of talk in recent months about inflation. In August the headline CPI was 5.3% higher than a year ago. It has been holding at this level for a bit more than 3 months. To put that number into context, the Federal Reserve targets a yearly rate of 2% on the PCE index (currently at 4.3%). A little bit of inflation is good, a sign of an expanding economy, but a sustained higher number is not so great. Inflation tends to lead to higher inflation because prices keep going up and up, which can lead to a number of problems, like hyperinflation. That’s why the Federal Reserve typically raises interest rates when inflation is rising as a way to slow down the economy and bring things back down to earth. Interest rates make borrowing more expensive, so people borrow and invest less.

The Federal Reserve’s thinking on the latest inflation data is that it is transitory, a temporary recovery stage after the slowdown from the coronavirus. A closer look at the data might suggest otherwise. In this article I will talk about two types of inflation, demand-pull inflation and cost-pull inflation. The former happens when demand outweighs supply and leads to price increases in products and is often a product of supply-related shocks. The latter is when wages and raw material prices increase in value and produces overall price inflation. One other notable factor in inflation is money supply growth which is discussed later.

Median sales prices of houses in the U.S. have increased roughly 16% year-on-year in Q2 2021. Housing prices can change due to a variety of factors (interest rates, the economy, local conditions) but what is more interesting is what’s happening with renters. Rent has increased 11.4% in 2021 up to August. Having initially slowed down at the beginning of the Covid-19 pandemic, it has surpassed its pre-pandemic trend. Housing measures make up around a third of the CPI.

At the beginning of the health crisis, the price of oil was quite low ($30 per barrel) and helped suppress inflation numbers, but it hit $80 per barrel recently. A few months after Covid hit, oil played a large part of the increase in inflation indexes. Other index components are now contributing to inflation. 

Some price increases will probably be temporary. A shortage of semiconductors, small microchips used in everything from computer to cars, became apparent soon after the health crisis began. One of the biggest increases we are seeing now is from used and new cars (up over 25% and 8.7% year-on-year, respectively) largely due to less cars being built because of the shortage. This will last until new semiconductor factories are built, which are expected in 2-3 years. 

At the beginning of Covid-19, ships were stalled in ports around the world as companies expected shipped goods to slow down as economies shut down. A year later, shipping costs have skyrocketed. The Baltic Dry Index, an indicator of shipping prices, is up 228% for the year (at 5062, a 10-year high). Expectations are that this will smooth over by this time next year.

Natural gas prices have increased worldwide especially in recent months. From a year ago, gas prices have nearly doubled in the US and more than quadrupled in the European Union. Slashed production and movement restrictions have led to low inventories. Last winter, record low prices turned into record high prices. It’s happening again this year. Some Chinese provinces are at risk of power outages because of supply shortages, possibly affecting the supply of some industrial products. Coal prices have also increased dramatically in the past year. India and the United States along with China are the 3 biggest consumers of the stuff also warn of electricity shortages. Coal makes up two-thirds of electricity generation in China and 70% in India, possibly slowing growth estimates for the year. The regulated price of coal in China hasn’t increased with the tight supply, forcing some power stations to go out of business instead of operating at a loss. An index from Business Insider has seen the price of coal go up 5x since January 6th 2020.

Pork prices have increased globally due to African Swine Fever (ASF), a disease that kills a pig within 10 days of contracting it. When farmers realize their hogs might have this, they usually end up culling the whole group. ASF has spread through China in recent years killing 40% of their hogs putting pressure on prices there (they have since come down). Largely sheltered from this, the United States is now at-risk of contracting the disease from the Caribbean (Dominican Republic, Haiti, Puerto Rico). 

Money supply refers to the total volume of money held by the public. Growth in this area can lead to inflation as explained by too much money in the system. I am seeing three recent examples which may be related to money supply growth. The first is stimulus packages signed by Donald Trump ($900 billion) and then Joe Biden ($1.9 trillion). This was composed of stimulus checks (equivalent to a total of $2,000 per adult) and unemployment benefit top-ups. The second is Joe Biden’s proposed infrastructure and social spending bill, currently being debated. Valued at $3.5 trillion, it may very well boost growth. Infrastructure investments like bridges and roads are generally good for the economy. The third is the Federal Reserve’s quantitative easing, which is a buying program of government and corporate bonds used instead of or in addition to lowering interest rates. The Fed is currently spending $120 billion monthly. The Fed’s total assets have ballooned to $8.4 trillion this October from $4.1 trillion in January 2020.

Raw materials have also increased in price. I couldn’t find an index of US prices so I went with its neighbour. According to Statistics Canada, the Raw Materials Price Index (RMPI) excluding crude energy products is at 127.9 in August 2021 (100 being as at January 2020). The Industrial Product Price Index (IPPI) was up by 14.3% in August 2021 from a year earlier.

The US unemployment rate is slowly dropping. September 2021 was at 4.8%, still above the 3.5% pre-crisis level. What worries me is that there are still millions of people who have not gone back into the workforce, causing labour shortages in some industries, who are in turn increasing wages and offering bonuses to try an attract new employees. Average hourly wages in the US are at $26.15 in September 2021, about $0.50 higher than the trend seen before the pandemic. Some people have retired, others are switching to safer jobs, but there is still a large chunk of people that are just not going back. Some folks are trying to milk the generous unemployment benefits that the federal government has thrown at them, but this has become a small number now. Not Seasonally Adjusted Insured Unemployed is 100,000-300,000 higher than before the pandemic (at around 2 million), compared with more than 20 million at its peak. Those who are working are also working more, with average weekly hours worked at 34.8 for US private nonfarm payrolls, up a little (+0.4 hours) compared to before the pandemic. 

There is an old theory in economics called the Phillips Curve. It says that inflation and unemployment have an inverse relationship. As unemployment falls, inflation is expected to rise, and vice versa. William Phillips hypothesized that low rates of unemployment will lead to a rise in wages, causing inflation. It’s important to note that this theory didn’t prove true during the high inflation-high unemployment of the 1980s US. If and when those previously employed pre-crisis 3-5 million people go back to work, those slightly higher wages might force companies to pass on the cost to consumers. Nearly 4.3 million workers quit their jobs in August (the most in two decades), they moved to higher-paying and safer jobs and left lower-paying ones with a shortage of labour, forcing them to increase wages further. People might also see inflation numbers going up and ask for a higher wage at work to compensate for it. Although inflation expectations aren’t generally a key factor when calculating inflation, it may end up being one to a new generation unaccustomed to sustained price increases.

One last point to consider is that Fed chairman Jerome Powell may or may not be re-appointed in February 2022. Recent trading scandals by members of the board have lead to some resignations and others terms are ending during Biden’s first term, allowing him to appoint people potentially more doveish and sympathetic towards his policies. Although they will require senate confirmation, Lael Brainard is seen as an option for the chairman or vice chair position. Considered a progressive, she could influence matters related to climate change and banking among other things.

Some of my points and examples may seem circumstantial, but the Federal Reserve expects inflation to last, at least, into some time next year.

In conclusion, I think what this data and past data shows is that we are dealing with an inflation experiment, where no one quite knows what will happen. We are faced with a never-seen before situation with different data and information than previous examples.

Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Department of Labor, Bloomberg, The Economist, New York Times, Reuters

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