Inflation just hit another high and the consensus appears to be it will go higher. It’s chic to pin this problem on the events happening now in Europe, but the core source of our current inflationary spiral pre-dates the Russian invasion.
The following comments from financial professionals are based on interviews conducted prior to the onset of the Ukraine conflict. These should shed some light on why inflation has spiked up in the last twelve months and why it might not go away quickly.
At the most fundamental level, the potential for an inflationary surge has existed for nearly two decades. “Interest rates are being held down incredibly low right now, therefore ‘easy money’ is being injected into the economy,” says Sam Dixon, Managing Partner at Oxford Advisory Group in Orlando, Florida.
For every action there is a reaction, and the eventual end of “easy money” action undoubtedly leads to an economic reaction that can initiate a sequence of cascading dominos.
“While Inflation is a focus, the real fear of the markets is that the cost of capital is potentially about to begin to rise, letting the air out of the balloon that has been risk assets for the past two decades since 9/11 and the beginning of the great deluge of liquidity,” says Gina Sanchez, Chief Market Strategist at Lido Advisors in West Hollywood, California. “For the past two decades, a combination of globalization, technological innovation and automation have conspired to drive down the costs of both goods (think commodities) and services (think wages) simultaneously, ushering in the greatest corporate margins in history. Combined with the cheapest cost of capital and greatest non-wartime fiscal stimulus in history as a result of 9/11, the Great Financial Crisis and the Pandemic, the rise in the valuations of everything from corporate equity to corporate debt to structures on top of corporate debt fed a wealth boom.”
The present bout of inflation has many fathers. Any one of them alone might not have been enough to spur it, but a coincidental series of unfortunate events may have been too much for our long era of low inflation to survive.
“The Federal Reserve has held interest rates at historical lows for far too long,” says Doug Carey, President of WealthTrace in Zionsville, Indiana. “They have purchased trillions of dollars of treasury bonds and mortgage-backed securities in order to keep interest rates low. In 2007 the Federal Reserve balance sheet stood at less than $1 trillion. Today it is nearly $9 trillion. The money they created to purchase these securities has found its way into various markets and consumers’ wallets. This was the first catalyst for inflation. Add to that record government stimulus and supply chain disruptions and now we have a perfect storm giving us the highest inflation rates in 40 years.”
Part of the problem may have been self-induced, with an overreaction (said only in hindsight) to a once-in-a-century black swan event.
“When the pandemic struck, the Federal Reserve created far more liquidity than the economy turned out to need,” says Josh Curtis, Founder & CEO at EQB in Richmond, Virginia. “Of course, if they had undershot, we’d be in the streets with pitch forks and torches. Turns out, there is no miracle monetary policy in the middle of a hundred-year public health crisis.”
At first, the stimulus money performed as expected. “Spending on goods rose dramatically since the start of the pandemic, fueled by stimulus payments and demand from consumers trapped in their homes,” says Daniel Kern, Chief Investment Officer at TFC Financial in Boston.
It’s easy to see now how this government stimulus ended up being over-the-top. While Washington might be forgiven for its initial 2020 foray into providing this money, it’s getting increasingly harder to justify what occurred in 2021.
“Inflation has been driven up by a culmination of Covid-related stimulus and the supply chain issues that were caused by various companies and governments shutting down production and keeping workers home,” says Nick Coleman, Financial Advisor at Bonfire Financial, Colorado Springs, Colorado. “In 2021, the government stimulus ended up pumping nearly 6 trillion dollars into the US. What is occurring is a new influx of money and burning desire to spend money, and lack of supply. This raises the prices for common products, as well as items that are larger, high-ticket items, such as homes and cars.”
The lack of counter-inflationary fiscal policy on the part of the Fed (in part due to fears of deflation at the start of the pandemic) combined with consumer spending has acted like a one-two punch.
“As we emerge from the pandemic, we currently have a high demand for goods, labor shortages and other supply chain issues spiking inflation,” says Daniel M. Keady, TIAA’s Managing Director, Chief Financial Planning Strategist in Charlotte, North Carolina. “In addition, we have inflationary impact from accommodative fiscal and monetary policy used to rebound the economy from the pandemic.”
It has been the supply chain issue that has received most of the headlines concerning inflation prior to the Ukraine war. That is not without some justification. “Supply chain issues are making everyday goods harder to find which increases demand and prices,” says Dixon.
While other elements have been cited, the stark reality of what’s been happening with the movement of goods cannot be understated.
“There are many factors driving inflation,” says Marc Lichtenfeld, Chief Income Strategist at The Oxford Club in Delray Beach, Florida. “Demand is still strong coming out of the pandemic with low unemployment and higher wages. On the supply side, the supply chain is still fractured with issues in China and staff shortages in the U.S.”
What once was an operational imperative has since been exposed as an operational vulnerability. And it’s almost impossible to retool systems so they can turn on a dime. In short, we were stuck with the world we had built.
“Just-in-time inventory approaches and import infrastructures, particularly the inefficient ports of Los Angeles and Long Beach, couldn’t handle the increased demand,” says Kern. “Semiconductor shortages added to the upward pressure on new and used auto prices. Consequently, goods inflation rose dramatically. Goods spending continues to normalize, reducing some of the goods-related inflationary pressures. There is not much that Fed policy can do to ‘fix’ issues such as clogged supply chains and semiconductor shortages.”
With the supply chain broken, it was impossible to keep up with the demand fueled by the ever-flowing dollars to a mostly idled workforce looking for things to do. There was only one direction prices could go.
“In 2021, supply chain disruptions drove inflation,” says Jon Lawton of OpenAir Advisers in Dallas-Ft. Worth. “Everyday purchases such as food, cars and energy have skyrocketed. Right now, used car sales are pushing inflation even higher. There aren’t enough semiconductors and chips available to make new cars. That backlog is due to the pandemic closing factories and disrupting shipping routes. Our reaction to Covid has become less and less, which is slowing down the abrupt nature of the economy and market reopening.”
The Covid lockdowns led to an unexpected response on the part of workers. Having tasted freedom, many decided not to return to work. This further exasperated the supply chain as companies found the human resources needed to meet demand scarce.
“The pandemic also forced global economic activity to take a pause, now dubbed ‘The Great Reflection’ which was followed by a collective shared unconsciousness leading workers to question their value in the markets relative to the risks, leading to the ‘Great Resignation’ and the ‘Great Retirement,’” says Sanchez. “Wages are now rising in real terms for the first time since the peak of wage growth in 1973. The fragilities of last mile logistics also proved faulty, causing companies to consider near shoring or on-shoring what used to be offshore activities like manufacturing or services support. These events have fundamentally shifted the narrative from deflation to inflation and to the fear that the Fed is about to set the US on a course to wring liquidity out of the markets.”
This unexpected reaction has caused reverberations from store shelves to Washington policymakers.
“Wage inflation and labor participation will be key to the outlook for inflation and Fed policy,” says Kern. “Wages have risen in response to an extremely tight labor market. About 5 million workers are out of the workforce because they need to care for children, more than 2 million have left the workforce because of Covid fears; retirements are more than 1.5 million above trend, and immigration is down to levels not seen since the 1980s. Lack of labor supply is a major underlying cause of the recent wage pressures, this is another factor in which the Fed is more bystander than driver.”
The steady increase in wages may have also been fueled by a number of states raising their minimum wage requirements. All this bodes ill for those who feel inflation will ease anytime soon or that prices will return to previous levels.
“We’ve been blessed with low inflation over the past couple of decades,” says Lawton. “But inflation will be sticky as we head into 2022. I expect there will be continued disruptions and slowdowns over the next year, which will cause prices to go up. Buyers and sellers of certain goods will be reluctant to change their prices even if supply and demand says otherwise. The one metric to watch is wage inflation. The price of cars can go up and down but once you increase wages it’s more permanent.”
And remember, all of the above quotes were collected prior to the Russian military action. This more recent incident has certainly caused some short-term inflationary push. You can rightly expect this marginal increase to go away once hostilities cease.
That doesn’t, however, change the calculus embedded in these quotes. Unless and until policy wonks begin to honestly assess their actions taken during and immediately after the pandemic, you may have to live with inflation a little longer than you would have hoped.