Don't Get Overheated About Inflation Just Yet

By Mike Bischoff, CFP

Sustained inflation is unlikely, but there are structural and economic factors to  monitor over the next 12 to24 months.

As we emerge from COVID-19 lockdowns, the U.S. appears poised   for a period of high growth. And along with rising GDP prospects,  inflation hawks have begun sounding alarms, unsettling investors. While we agree that the potential for rising inflation is something to take seriously, the inflation story is not so simple—partly because   the Federal Reserve has been clear that its reaction to inflationary  pressures will be different this time. We think that there are three   important phases to consider in the inflation story.

Phase 1: The Impact of base effects

Currently, core PCE inflation (the preferred metric of the Federal Reserve) is about 1.5% year-over-year and is expected to rise this year. This increase is mostly due to the increased demand for services as the economy reopens and the expiration of certain pandemic-related medical reimbursement programs (health care spending is approximately 18% of PCE.) Because of the sharp drop in inflation in March and April of 2020, any normalization this year will look and feel inflationary.

Phase 2: Capacity constraints, supply chain issues and increasing fiscal spending

 

As vaccinations increase and the economy fully reopens, we expect to see a return to the activities we’ve all missed while in quarantine like traveling and dining out. The resumption of these activities, likely in the summer/early fall (assuming there will be no adverse impact from COVID variants), will generate inflationary pressures. There could also be upward pressures on prices from supply constraints in revived sectors. We expect that this inflationary pressure will also be transitory in nature-since, at some point, demand for services will be normalized.

Phase 3: Employment rebounds and inflation meets-or exceeds-the 2% target

 

Historically, the Fed’s inflation bogey has been core PCE above 2%, an the market has extrapolated that a level above that threshold would trigger the central bank to raise rate. But the Federal Reserve has evolved its thinking around inflation. In statements this year, Fed Chair Powell has stated that the central bank would not act to counter inflation by raising interest rates until labor market conditions have reached levels consistent with it’s assessments of maximum employment.

 

The bottom line: Keep calm and carry on (being vigilant)

 

Near term, inflation will be transient rather than persistent. But this doesn’t  mean the pressures will be any less real for markets and investors as the economy recovers.