The current debate about whether the spike we are seeing in inflation is “transitory” should be reframed as “reflation vs sustained inflation.” Just like many other economic data points (ISM, confidence, employment) the recent inflation measures represent a resurgence from the mid-pandemic lows and a positive sign of economic recovery. We believe it is also short term and should not be misconstrued as the long run intention of the Federal Reserve’s actions.
The dual mandate of the central bank is employment and price stability. It has been very transparent with the price stability target and its goal of reaching sustained inflation averaging 2-2.5 percent over time. April’s 0.8 percent increase is well over the target, but it is mostly in the “transitory” reflation category. It is important to be clear: reflation doesn’t mean high inflation. The “transitory” reference puts an implied cap on higher inflation prints. It assumes near term inflation will be driven by the base effects of the deflationary economic environment in the second quarter of 2020, at the onset of the pandemic, and inflation will subsequently settle back to the long run averages. However, investors should also recognize that the long run outcome of the Fed’s actions (if they work) will result in sustained inflation above the averages we have seen for the last 10-20 years.
It is expected that the second quarter will show seasonally high inflation even with minimally high increases over last year. The monthly inflation prints for March, April and May 2020 were -0.3, -0.7 and -0.1, respectively. The combination of simple math and widely known inflationary factors (disrupted supply chains, commodity prices, labor market inflation, Fed action) were bound to have an impact. Even if April CPI had increased at the consensus 0.2 percent, the headline number would have accelerated to 3.6 percent. Instead, April printed 4.2 percent which is the highest since August 2008. The same may hold true for May.
The components of the report highlight a combination of supply issues and economic reopening. Used cars prices were up nearly 10 percent reflecting shortages and stimulus checks, while increasing mobility boosted some sectors including hotels (8.8 percent) and airfares (10.2 percent). It also should be noted that traditional measures of inflation may not be appropriate as lifestyles have changed over the last 12-18 months. Headline inflation data is likely not capturing what the consumer is experiencing. The basket of goods used for CPI suffers from lack of substitution and does not represent all production and consumption in the economy. Going forward, accelerated labor costs (wage inflation) could present an economic hardship for businesses trying to recover - particularly businesses that require low skilled labor and have price inelasticity.
This may be a wake-up call to the Fed and perhaps it will take this opportunity to lay the groundwork for more sustained inflation further into the recovery. Ultimately, that may not be the case and regardless of how high the numbers get over the next few months they will continue to be dismissed as temporary by central bankers. We believe the focus will remain on the employment part of the dual mandate. As Chairman Powell noted in his last press conference, “payroll employment is 8.4 million below its pre-pandemic level, and this figure understates the shortfall in employment as participation in the labor market remains notable below pre-pandemic levels.”
As we moved past the first anniversary of the onset of the pandemic the lagging impacts of COVID-19 were still dictating many aspects of daily life. On a positive note, there is tangible evidence that the situation is improving both from an economic perspective and, perhaps more importantly, from a quality of life perspective. As we proceed through 2021 increased mobility will lead to an increasingly active consumer and businesses seeking to recover and expand will continue to make capital investments. However, post-reflation challenges will remain. Simply getting back to 2019 economic benchmarks is in process but the taller task will be laying the fundamental groundwork for sustainable and equitable economic growth in 2022 and beyond.