Let's Talk About Inflation

Recently, updated data regarding the Consumer Price Index, or CPI, has rocked investor confidence. Last month, the Bureau of Labor Statistics reported that in the past 12 months, the "All Items" Index increased 4.2%, which is the largest increase since September of 2008. Needless to say, this type of inflationary data is concerning. However, are things as bad as headlines are reporting?

In typical vernacular, we often talk about any price increase as "inflation". However, as discussed by James Liu, CFA® (Founder and Head of Research at Clearnomics), it is important to distinguish between three factors at play in the midst of this post-pandemic recovery. Learning about and understanding these factors can help investors sift through attention-grabbing headlines and be properly positioned in the years to come.

First, some prices are simply bouncing-back from historically low levels. Oil, for instance, plummeted at the onset of the nationwide lockdown last year, with the front-month contract falling into negative territory for the first time in history. Even with no changes to the oil industry, it would be expected for prices to rebound as the economy reopens. The fact that these price increases are large on a percentage basis is due to the low starting points last year. Economists often refer to this phenomenon as "base effects" - i.e., prices coming off a low base.

Second, there are supply and demand imbalances in certain industries that are causing prices to soar. This is true in semiconductors, housing construction, agriculture, gasoline and many more areas. In most cases, this is what captures the attention of news headlines and the general public.

Each industry has its own supply and demand story. For instance, semiconductors are facing shortages due to strong demand for work-from-home technology, graphics cards for cryptocurrency mining, increased car-buying, and more. There are also supply factors such as disruptions to the global supply chain and droughts that threaten water-intensive chip manufacturing.

In most of these cases, the supply and demand imbalances should resolve themselves over time. And while this may be "inflationary" if it affects a wide variety of goods at the same time, this is not usually what investors worry about when they think of that term, even if it does affect consumers in the short run. After all, the skyrocketing price of toilet paper during the pandemic wasn't referred to as inflation, since it was understood to be temporary.

Thus, the third factor is a broad rise in prices across the economy due to monetary and fiscal stimulus. This is textbook inflation caused by increases in the money supply and/or the velocity of money - i.e. the pace at which money is spent. Unlike an energy pipeline disruption, the effects of this type of inflation is theoretical and can be harder to see.

Monetary inflation is not a universal concern among economists today. Although loose monetary policy was one reason for the inflation of the 1970s and early 1980s, Fed stimulus after the 2008 financial crisis did not result in the inflationary pressures many expected. Additionally, there have been strong deflationary forces over the past several decades as prices fall due to globalization, technology and other trends.

As always, if you have concerns regarding your own portfolio and how inflation may or may not affect it, please don't hesitate to reach out. We're glad to help in any way we can.