Inflation can be a frightening prospect, whether you remember the long gas station lines of the 1970s or you’ve never before seen a major jump in the price of a gallon of milk. But a little perspective suggests there is no reason to panic right now.
In September, the Federal Reserve updated its inflation outlook to exceed 4% in 2021, well above the central bank’s 2% target. Even excluding volatile categories like energy and food, inflation has not been so high since the early 1990s. But the Fed also said that this spike in inflation is likely temporary. The hyperinflation of the ’70s is not around the corner, at least according to central bankers.
To understand why, it is important to step back and consider the basics of inflation. If you took economics in school, you likely learned that the basic cause of inflation is too much money in circulation and not enough to buy with it. If the supply of money grows too much relative to the size of the economy, the value of an individual dollar (or euro, or pound) falls. Similarly, if a natural disaster — or a pandemic — constrains manufacturing or shipping, “cost-push” inflation can result. Whether there is too much money or too little access to goods and services, or both, prices rise.
In the real world, this explanation is something of an oversimplification. The underlying principles are sound, however. To evaluate our current round of inflation, we should consider which conditions apply and whether they are likely to last.
Inflation Cause #1: Too Much Money
Critics have claimed that President Joe Biden’s proposed $3.5 trillion stimulus package will spur longer-lasting inflation. This spending, they argue, will follow COVID-19 stimulus and rock-bottom interest rates in pumping cash into the American economy. Yet recent history, at home and abroad, suggests that the connection between stimulus and inflation is more nuanced.
First, globalization and technology serve as dampers on the potential for ’70s-style runaway prices. Worldwide production and the “Amazon effect” have created a different economic environment. We have already seen this in action. A CNN poll in March 2008 found 91% of respondents worried about inflation as the housing market remained in free fall during the financial crisis. But despite hundreds of billions of dollars of government stimulus designed to stave off a recession, fears of double-digit inflation were never realized.
There are also many moving parts in a modern economy. Consider Japan, which has the greatest public debt of any developed nation, at over 260% of its gross domestic product. An aging population and a sluggish economy have led to decades of deflation. Today, Japanese officials continue to battle declining prices as the pandemic has kept prospective shoppers at home. An aging populace has all the more reason not to take risks in the coronavirus era. Still, Japan’s deflation long predates the pandemic. Not only has repeated government stimulus not triggered serious inflation; it has barely helped the country escape deflation.
Americans should also remember that just because the president wants a particular policy enacted does not mean the legislature will oblige him. Dampers from moderate Democrats as well as from Republicans could mean the stimulus passes in a reduced form, as Biden has already told his fellow Democrats to expect, or not at all. At this writing, the bill’s future remains in doubt. It is far too early to count on this government spending, much less forecast how it will translate into the overall level of currency circulating in the economy going forward.
Inflation Cause #2: Not Enough Goods
Constraint on supply, not over-availability of money, was the main cause of the double-digit inflation the U.S. experienced more than 40 years ago. The government spent heavily on the war in Vietnam, but many modern economists think the more significant culprit for the era’s inflation was the 1973 oil embargo. Saudi Arabia and allied nations blocked oil exports to the U.S. and some of its allies over its support of Israel in the Yom Kippur War. Economists disagree over whether the embargo directly pushed prices higher across industries or whether it mattered primarily because of its effects on consumer expectations and monetary policy. Either way, gasoline prices nearly quadrupled over the course of three months.
Today we can also connect our more modest spike in inflation to the supply chain. Raw materials have become more expensive just as consumer demand begins to rise. This is especially true in countries, like the U.S., where COVID-19 vaccines are beginning to facilitate a return to some of the normal rhythms of life. Certain industries are now experiencing staffing shortages and shipping problems, too. These have further constricted supply as demand rises.
One well-known factor is the shortage in semiconductors. This shortage has held up manufacturing in a variety of sectors, notably including automakers. The used car market experienced a whopping 41.7% increase in prices between July 2020 and July 2021. A recent wave of COVID-19 cases in Malaysia, Vietnam and the Philippines has caused new bottlenecks in microchip production, frustrating auto companies hoping to get back to a normal manufacturing schedule to meet increased consumer demand. Current predictions for how long the semiconductor shortage will last range from the beginning of 2023 to the end of that year.
Extreme weather events can affect supply too. An unusual frost in Brazil and the heat wave in the U.S. Pacific Northwest hurt harvests for coffee and fruit. The February storm that slammed Texas temporarily closed many plants that suppliers relied on to create product packaging. And surging fuel prices make shipping raw materials and finished products alike more costly. Those prices are, in turn, elevated in part because of disrupted supply chains. To make matters worse, truck drivers are among the many professions where employers are having trouble filling positions with qualified applicants. All these factors can contribute to higher prices for customers. In some cases, it may also lead to “shrinkflation”: customers pay the same amount for a smaller amount of product.
One area where inflation may linger longer than others is in housing. The most recent data from the S&P CoreLogic Case-Shiller National Home Price Index at this writing showed a 19.7% increase in U.S. home prices over the last 12 months — the largest annual jump since 1987. A report from Realtor.com pegged the shortfall between demand and supply for homebuyers at more than 5 million homes. While pandemic-related supply chain disruptions and labor shortages have also hit the housing market, they aren’t the only culprits. Local building restrictions and NIMBYism hampered construction even before the pandemic, especially as the construction of affordable housing became less and less profitable for homebuilders. We may need government intervention to incentivize building more nonluxury units if we don’t want to face a tight housing market for years to come.
Across industries, solving the logistical issues affecting the flow of products may take time. Before the pandemic, many industries relied on “just in time” fulfillment. Manufacturers would order raw materials from suppliers for delivery exactly when they were needed in the production process. In normal times, this strategy increased efficiency, but it left no slack for shipment delays and other disruptions. Some enterprises may choose to retain more of a supply cushion going forward; others may eventually return to leaner pre-COVID strategies. In either case, consumers may have to wait a year or more for the dust to settle. But it is in everyone’s interest to fix the country’s supply chains, so it will happen as soon as it is practical.
What’s Next
The Federal Reserve continues to assert that the inflation the U.S. is experiencing will be transitory. I tend to agree with this prediction. As Fed chairman Jerome Powell said recently, supply-chain bottlenecks from the pandemic have put upward pressure on prices. “These bottleneck effects have been larger and longer-lasting than anticipated,” Powell said in September. “While these supply effects are prominent for now, they will abate. And as they do, inflation is expected to drop back toward our longer-run goal.” With enough time, the supply chain will reach a new equilibrium. As for the fiscal side of the equation, even if Biden’s plan makes it through Congress unchanged, government spending will inevitably ebb and flow as priorities shift and power changes hands.
The Fed also retains a variety of tools to check inflation, should it defy expectations and continue to climb. Interest rates currently remain near rock bottom. The central bank is also buying around $120 billion in Treasury and mortgage bonds each month. Dialing back bond purchases and raising interest rates can both effectively serve as monetary brakes on inflation, and there is plenty of room for the Fed to do either or both.
For now, we have not reached a point where Americans should be alarmed about inflation. U.S. inflation has remained below the Fed’s 2% target for years. In fact, the Fed has said it may let inflation run slightly above 2% for a while to compensate for the years it was unusually low. Younger adults may find this outcome unnerving, as they have never lived in a world with noticeable inflation. Yet from an economic perspective, it represents a return to a more historically normal reality. More inflation than we’re used to is not, in itself, a reason to worry. And the Fed has made clear that it will not let inflation run unchecked. This should help prevent a toxic cycle in which fears of inflation lead to businesses raising prices, creating a self-fulfilling prophecy.
One other key area to watch is wages. In general, sustained inflation requires a corresponding rise in worker compensation. This was a key element of the inflationary cycle of the 1970s. Workers demanded higher wages in the face of rising prices, and businesses in turn raised prices further because they expected to pay out more in wages. It is not clear that we are seeing anything similar now. Some observers were alarmed by the August 2021 jobs report, in which the Bureau of Labor Statistics reported that wages rose even with weak hiring. But wages have been more or less stagnant for many years, and most of the new growth has been concentrated among low-wage earners. It is not at all obvious that the sort of upward adjustments happening now are excessive enough to fuel an inflationary cycle. The Wall Street Journal recently observed that “real” wages (that is, pay adjusted for inflation) fell 0.5% in August 2021. Unless wage growth is sustained and reflected across all levels of the workforce — possible, but far from inevitable — it is likely not enough to keep inflation rising.
How high inflation will go, and how long it will last, are questions for which experts can at best offer educated guesses. Yet investors have no reason to make any major changes due to present inflation or the prospect of it extending into the future. Portfolios heavily invested in stocks are unlikely to take a major hit, as companies experiencing higher material prices and shipping costs will pass on those increases to their customers. And higher inflation may also mean interest rates on cash and money market funds rise after years near zero.
No one likes paying more for a gallon of gas or a loaf of bread, and it may not be pleasant to see headlines about annualized inflation “spiking” or “skyrocketing” as prices continue to climb, even if only slightly above the Fed’s 2% target. But a certain amount of inflation is a normal part of the economic cycle. In the absence of unforeseen factors, consumers and investors alike have no cause for serious alarm.
