Inflation is Here; How Worried Should You Be?
By Brittany Mollica
Google searches for ‘inflation’ have hit record-highs, and it’s easy to find headlines these days expressing concern about rising prices. People are understandably concerned: the US Bureau of Labor Statistics reported in June that we’ve seen a 5.4% increase in prices over the past year – that’s the largest 12-month increase since 2008*.
But before we decide whether to worry about rising prices, let’s explore what inflation is and what typically causes it. A brief Econ 101 lesson:
Inflation is a measure of the rate of rising prices of goods and services in an economy.
It is commonly measured by the Consumer Price Index (CPI), which measures the current price for a basket of goods and services and tracks the change in price over time. An alternate, and similar, metric is the Personal Consumption Expenditure price index (PCE).
The Federal Reserve monitors the level of inflation in the United States. The Fed’s current target is a 2% rate of inflation (measured by the annual change in the PCE price index).
Potential causes of inflation include:
An increase in production costs, such as an increase in the cost of raw materials or transportation, or rising wages for workers.
An increase in demand for products.
Having too much money in circulation.
Consumer and business behavior can also drive inflation by increasing inflation expectations – if you believe prices are going to increase in the future, you’re more likely to buy now to reduce the risk of having to pay a higher price later. If enough people or businesses have the same mindset, this alone will increase demand and can lead to higher inflation.
In short, inflation = more dollars seeking fewer goods and services.
As charted by the Federal Reserve Bank of St. Louis (below), inflation has been low for several decades. This long period of low inflation makes the current uptick feel drastic, but we can see that it still pales in comparison to inflation experienced in the 1970’s and early 1950’s.
Although we aren’t seeing 1970’s levels, we have indeed seen an increase in prices this year in the US (if you’ve tried to book a rental car or buy a home, you know exactly what I mean). We believe the rise in prices has been driven by a combination of factors, mostly stemming from the global pandemic:
Pent-up demand: as more people get the COVID-19 vaccine and the economy reopens, consumers are thrilled to get back to a “normal” way of life. Add to that the fact that many people have cash saved up – credit the massive amount of fiscal stimulus over the past 18 months – and demand has spiked in numerous sectors, particularly hospitality and tourism.
Decreased supply: from labor shortages to material shortages (such as plastics and semiconductors), many industries have dealt with disruptions in their supply chain due to the pandemic. Don’t panic now, but recent news articles even warn of a liquor shortage.
Given these factors, it isn’t shocking that prices have risen; not only did the Federal Reserve anticipate this, but we discussed the possibility of inflation in Hilltop’s February economic outlook, before prices had started noticeably rising. The Fed describes the current inflation as “transitory”, meaning it should be short-term. This is largely because the increased demand for goods and services isn’t likely to exceed the economy’s long-term ability to produce them. In fact, high prices are a signal and incentive for producers to create more supply, so we expect to see a moderation in prices as supply chains return to normal.
At the same time, there are several non-pandemic-related factors that could eventually lead to higher inflation long-term. A few examples: baby boomers retiring from the labor force, peak globalization, stimulative fiscal policy, and rising wages. However, despite the risks, investors should remember that inflation is not always a bad thing. Data shows that since 1976, stocks and bonds performed best when inflation ranged between 2-4%**.
All of this to say: inflation is not inherently something to fear, although heightened inflation expectations may cause additional market volatility this year. Our recommendation is to remain invested in a diversified portfolio that holds both stocks and bonds, allowing you to get exposure to a variety of countries, sectors, and asset classes. It could also make sense to add an allocation to a more inflation-resistant investment, such as TIPS, commodities, energy, or real estate. But most importantly, we recommend that you seek advice from an investment professional and that you keep your longer-term financial plan in mind as you’re making investment decisions.
* https://www.bls.gov/news.release/pdf/cpi.pdf
** https://www.schwab.com/resource-center/insights/content/is-higher-inflation-coming
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