After many years of stubbornly low inflation, we are now in an environment we haven’t seen for 40 years. Prices are going up – fast. The Federal Reserve initially believed rising inflation would be transitory (i.e. fleeting) but has since changed their tune. Trying to get inflation to return to normal, the Fed has started raising interest rates. While the beginning of the end of easy money may help curb inflation on the margin, investors should prepare for inflation to linger.
The Personal Consumption Expenditures (PCE) measures the change in the prices of goods and services consumed by all households and nonprofit institutions serving households. The Core PCE excludes food consumed in-home and energy prices.
The CPI or Core CPI are the most common measures of inflation, but for several very good reasons, the Federal Reserve prefers to the Personal Consumption Expenditures (PCE) price index instead of CPI. For reference, the latest year-over-year figure for CPI is 8.54% and 6.44% for Core CPI.
When thinking about inflation, remember these metrics are the rate of change, not the prices themselves.
Here’s an example:
Between June 2020 and June 2021, the Bureau of Labor Statistics reported a 45% year-over-year increase in the prices of used cars and trucks. Now imagine that the June 2022 report shows the cost of used vehicles drops -15%, a big number. Are used cars cheap? Not really – the annual rate of change is being calculated off a high number, so despite the -15% decline, prices would still be roughly 24% above what they were in June 2020, and 20% above 2019 prices (cumulatively).
4 reasons inflation may not return to normal right away
Wage growth and unemployment
Wage growth is high as the demand for workers far exceeds the number of people actually looking for a job. As of February 2022, there were 10.78 million job vacancies in the US. The problem is there are only 5.95 million people who are unemployed and actively looking for work as of March 2022. This means there are nearly two jobs open for every unemployed worker. The demand for labor has pushed wages up as employers try to compete.
These facts have several implications for inflation:
- Wage growth will help support consumers’ ability to spend on goods and services, even as inflation persists. This means rising prices may not affect demand as much.
- There’s a risk of a negative feedback loop with wages and inflation: as inflation goes up, workers demand more pay to continue the previous level of consumption. Wage growth can be particularly sticky.
- The labor shortage is exacerbating existing supply chain issues and challenges for businesses to meet consumer demand.
- The labor market shortage has been fueled by several factors. The ‘great resignation’ is one, though perhaps overstated at this point. The working-age population is aging, the birth rate is declining, and recent efforts to curb immigration are all reducing the pool of available workers. Further, even if sidelined employees come back into the labor force, with over 4.8 million unfilled jobs out there, there’s a lot of room for households to increase their income to avoid decreasing their consumption.
Wage growth and the increase in asset prices during the pandemic has helped support above-trend disposable personal income in the US.
US disposable personal income (billions)
Supply chain issues aren’t helping normalize inflation
The Federal Reserve can only try to fight inflation from the demand side. Unfortunately, the supply side has played a role in persistent inflation. China’s zero Covid policy is stalling global supply chains as residents go into lockdowns.
The supply chain disruptions from Covid-19 are likely to have a lasting impact on manufacturing and logistics. Offshoring and just-in-time inventory management systems leave little flexibility during a pandemic (or endemic). As a result, many businesses are actively working to on-shore or near-shore at least part of their operations. This takes time.
Russia’s invasion of Ukraine has a major impact on commodity markets
Russia and Ukraine are major exporters of some key commodities including wheat, sunflower, and fertilizer. The invasion of Ukraine means many of these key food sources aren’t going to be planted this season. And troops continue to block key shipping channels in the region. Sanctions against Russia will make some countries forgo Russian crops. The likelihood of a global food shortage has driven up prices on these goods.
Similarly, sanctions against Russia also has major implications for energy markets, particularly in Europe, which relies heavily on exports from Russia. These price shocks are highly visible for consumers at the pump but have other inflationary implications as well. For example, few airlines hedge their fuel costs. Airlines must pass the costs onto customers and/or cancel some flights. Travel was already expected to be near all-time highs after the pandemic.
The housing market is hot
After reaching a record low in January 2022, the total housing inventory in the US is starting to rebound, albeit slightly. The pandemic exacerbated an already tight housing market due to low inventories, supply chain delays, worker shortages, and rock-bottom interest rates which increased buyers’ purchasing power. The housing shortage has hit first-time homebuyers looking for entry-level single-family homes the hardest.
Total Housing Inventory (number of single-family and condos units available for sale, in thousands)
The Case-Shiller National Home Price Index is up over 19% year-over-year and currently sits at all-time highs. After hitting all-time lows at the end of 2020, the average rate on a 30-year mortgage has increased nearly 60% in the last 12 months. This will inevitably deter some buyers, though in many cases it means one more existing home won’t be hitting the market.
Further, anecdotal evidence suggests many higher-end buyers are forgoing mortgages altogether in favor of more competitive cash offers. In this case, rising interest rates may not end up curbing demand much in the luxury home market.
National home prices and mortgage rates
Managing your finances when inflation is high
Given the strength of household balance sheets and how far monetary policy has to go before actually getting tight, taming inflation won’t be easy.
People often feel compelled to act when nervous about the future. Famed investor Peter Lynch: “Far more money has been lost by investors preparing for corrections or trying to anticipate corrections than has been lost in corrections themselves.”
Rather than trying to prepare for the next event, take steps to plan for any type of personal financial crisis. The economy goes through the business cycle at different paces, just like markets will experience different rotations and investing environments. While you can’t time or control it, you can change how prepared you are, which includes diversification and maintaining flexibility with expenditures, especially during periods of high inflation.