Inflation: The Transitory Question

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After a brief delta variant scare, the global economy has resumed its course towards a new, post-pandemic normal. Driven by increased vaccination rates and resilient consumer mobility, the prospect of an imminent full recovery places the spotlight back on inflation as a growing policy concern for consumers and companies alike. A survey conducted by the New York Fed reveals that consumer expectations for inflation for the next three years rose again to 4.3% from 3.0% in Q1 2021. Persistent inflation, alongside a stubborn pandemic and the Evergrande debacle, has depressed optimism to all-time lows in the US as the University of Michigan’s August census recorded the lowest consumer sentiment rating since the 2008 financial crisis. We have seen comparable shifts in attitude north of the border— Ipsos’ Index of Canadian Consumer Confidence has trended steadily downwards in Q3 2021 and Bloomberg corroborated this narrative with a report that inflation was explicitly mentioned as a concern in 87% of Q2 earnings calls for S&P 500 companies. Note that these metrics serve as much more than a series of mood tests: fears about rising prices introduce upward pressure on wages, which in turn leads to firms passing costs down to consumers.

A key subset of these factors are by-products of the unprecedented rate of recovery after the pandemic recession.

In addition to the consumer expectation spiral, there are structural components that have kept inflation running hot. A key subset of these factors are by-products of the unprecedented rate of recovery after the pandemic recession. All-time high levels of disposable household income, combined with pent-up demand coming out of lockdown have stretched already-frail supply chains. More specifically, severe shipping bottlenecks worsened in August as nearly 40 Panamax-size container ships were anchored off the Californian coast, queuing up to unload. The issues on the offloading end can be attributed to business components, such as the spillover from reduced air freight capability and reduced rail capacity, but there is also a human aspect in the form of labour shortages. COVID-19 has constricted the number of workers both on the docks and, perhaps more importantly, in the trucking industry. Even prior to the pandemic, there was an exodus of drivers as the industry faces headwinds in demographic and increased regulation.

In light of this information, how do central banks intend to enforce price stability?

The US September CPI data released on October 13th surprised again to the upside, with headline CPI coming in at 5.4% above the previous year. In light of this information, how do central banks intend to enforce price stability? In the United States, the Federal Reserve has always been careful with using monetary policy to fight inflation, not wanting to jump the gun and prematurely stifle growth. The Fed Chair, Jerome Powell, has expressed the view that current levels of inflation are “a cause for concern” during his speech at the annual Jackson Hole symposium, but emphasized that his concern is “tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.” However, in the latest September FOMC meeting, central bankers announced that they would begin reducing the rate of asset purchases in November. While this act of “tapering” is not explicitly tightening, it does move up the timeline for liftoff.

In Canada, the August CPI reflected prices 4.1% higher than the previous year. While the Bank of Canada (BoC) has been objectively more hawkish than the Fed (having begun its tapering program in October 2020), they have been similarly calm in their outlook. Echoing his American counterpart, BoC governor Tiff Macklem stated in a recent public appearance that there are “good reasons to believe that [inflation drivers] are temporary”. 

Conversely, those who believe inflation is more persistent would argue the sharp acceleration in long-term drivers…will keep inflation sticky.

The narrative supporting the transitory argument is one of normalization. In part, this cites “base effects” that create an illusion of outsized price increases this year due to unusually low prices in the year prior. They also characterize the response from producers to the aforementioned bottlenecks as lagged due to circumstantial considerations, but inevitable nonetheless. As Dr. David Kelly from J.P. Morgan Asset Management states, “high prices provide a powerful incentive for producers and distributors to get goods to market”. This means supply will eventually catch up with demand and alleviate the cost push. Conversely, those who believe inflation is more persistent would argue the sharp acceleration in long-term drivers such as owner’s equivalent rent and inflation expectations will keep inflation sticky. An additional point of contention is the labour market. The transitory camp highlights the smaller current workforce compared to pre-pandemic levels: the September payroll report indicates 5 million fewer jobs and a smaller workforce headcount by a factor of 3.1 million. The claim is that people will be going back to work with the reopening of schools and the drying up of stimulus savings should correct the labour shortage. On the other hand, the increase in job openings from month to month seems to suggest a tight labour market and, in turn, further wage inflation that central banks are missing.

The bottom line is that we are in a time of extreme uncertainty after a truly unprecedented catalyst that has disrupted economies around the world. At the time of writing, it is still unclear whether the recent inflation data should be viewed as a longer-than-expected stay that will eventually fade or a structural issue that must be met with hawkish monetary policy. That said, one thing is clear: not everyone is buying the calm, transitory rhetoric that central banks are selling.

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