Balancing the Inflation Tightrope Act: Should You Be Worried?
As the world recovers from COVID19, its now the world’s economies that are running hotter than predicted. But with growth has come a surprising change. The sharp increase in inflation blindsided many economists and almost no one saw it coming.
This year, inflation has been the least predictable it’s been for a long time, probably in decades but is this high inflation just a temporary blip or could it spiral out of control? It’s the most important question for the global economy right now. Inflation is when prices rise over time. It’s when items and services from bananas to belts and housing and heating cost more than they use to. Meaning you get less bang for your buck.
Keeping inflation steady is a balancing act. Most world Central Banks aim for prices to increase by about 2% a year. At that level consumers don’t notice the changes in prices too much but when it becomes high it can become problematic. You can have a little over 2% a lot of the time and not worry too much about inflation or you can have a lot over 2% over a short period of time and not worry too much. What you don’t want is a lot over your target for a long period of time because that going to start causing major economic problems.
For years the question policy makers were asking was, “Why is inflation so low?” Over the past 10 years the world’s economies were strong, and unemployment was low, and economists were puzzled as to why prices hadn’t taken off as much as they would have expected them to given the economic environment at the time.
The pandemic, certainly in 2021 seems to have turned everything on its head and we have seen the resurgence of inflation, especially in the US and that’s led people to ask if the era of low inflation is over?
In the US, inflation has hit 6.2%. In the EU inflation has reached 4.4% and in Venezuela inflation rates have reach 9,986% this year.
Up until this month, the Fed as well as many of the world’s Central Banks were still forecasting that inflation would eventually fizzle out and that there is no need to worry. However, in a rare admission last week, Federal Reserve Chair, Jerome Powell admitted the Fed got it wrong on inflation, saying they should stop calling it ‘transitory’. Our confidence in that judgement is now somewhat undermined by the fact that the Fed and Central Banks didn’t see this burst of information coming which revealed that even the Fed’s power to forecast accurately isn’t always right.
The worst-case scenario could be runaway inflation like that seen in the US in the period known as the Great Inflation. Rates spiked to over 14% by 1980. The root cause of this was the Federal Reserve’s easy monetary policy and rising oil prices. But what’s causing inflation this time around? The first clue is in the way inflation is calculated. Some economists think that in real terms inflation hasn’t actually risen that much. It just looks higher due to the sharp dip in prices in 2020. For example, the cost of crude oil in September of this year was $71 per barrel compared to September of 2020 when prices were recovering from near collapse. Using this data, year over year, the price of oil has risen by 74% but if you compare it to September 2019, it’s only a 13% increase. This is known as a Base Effect and could explain why the many Central Banks up until last month, thought inflation wouldn’t last.
But there are other important factors that are causing inflation. Supply chains have been hugely disrupted by the pandemic while at the same time, as the US economy has begun to emerge out of the pandemic, increased demand has driven prices higher. Increased demand is, thanks in part, to big government stimulus polices. The US for example poured $1.9T into a COVID relief package over a very short period of time. Almost a 5th of US dollars in circulation by the end of 2020 were created that year and people are spending those dollars with gusto! For example, the issues with supply chain impacting auto manufacturers’ ability to get computer chips required in all modern vehicles today has choked off supply while simultaneously driving up the cost of used vehicles. Used car prices have been a major driver of inflation. In the past year alone used car prices have risen by nearly 45% although recent months have seen a decline.
Food is also seeing substantial price increases globally because of not only pandemic related supply chain disruption but also because of extreme weather which has led to crop shortages. Food and fuel is a big part of the expenditure of the economically challenged and when prices go up a lot they reduce people’s living standards and this tends to be more true for people with the lowest socioeconomic status.
It is however possible to slow inflation and this is where the real balancing act comes into play. The power to do so is in the hands of the Federal Revere here in the US and the Central Banks of the world. They can do this by raising interest rates. What happens when you raise interest rates, generally is that people become more inclined to save and less willing to invest and slowing the economy slows the rise in prices of goods and services. The trick is in how much and how fast to raise rates. Too much or too quickly can cause a chain reaction in an economy that could lead to a recession or in a perfect storm environment, a depression. If this happens the government can backtrack the increases, but it can take some time for the economy to recover from the dip.
Central Banks across the world have either begun to tighten interest rates or have telegraphed that they will in the coming months. All in an effort to ensure that inflation starts trending back down but also to signal to the public and investors that they don’t want inflation to be so high and that they are creditably fighting it.
People expectations are the final piece to this story. Inflation depends on whether people think inflation will get out of hand. Inflation expectations are in many ways self-fulfilling. If people don’t think inflation is going to get worse or last very long, then it won’t however the opposite is true as well. Managing people expectations is difficult, especially in such uncertain times. Normally as long as the Fed and the Central Banks are worried and therefore watching, you may not have to be. What’s been a little unsettling in the pandemic is that the Fed and the world’s Central Banks have been caught off guard but as long as these institutions maintain their independence and focus, we should be alright.
Investment discipline means you have a strategy to meet your goals, minimize risk, and minimize costs. Don’t be tempted to make emotional decisions. 2020 was a prime example of the benefits discipline can bring to an investment portfolio.
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