Editor’s Note: We are excited to have Mihir Saudagar, one of Cornerstone’s newest team members, guest author this edition of Independent Insights. Kevin will be back for the next issue.

Inflation, a word which for decades has been an afterthought, is being discussed quite a bit nowadays. The last time this nine-letter word generated so much debate was during the oil crisis of the 1970s. Currently in developed countries, such as the United States, inflation remains stable and low. The annualized inflation for the United States for the past decade has fallen short of the Federal Reserve’s target rate of 2% per year. Since inflation has languished, much more talk over the past generation has been geared towards the second of the Fed’s mandates: the unemployment rate. During times of economic tumult, the insidious effect of rising prices does not grab headlines like people who have lost their jobs.

Due to deliberate actions taken by the Fed and Congress in response to the COVID-19 crisis, the economy received much needed support and has seemingly got back on track. Monetary authorities loosened policy by dropping interest rates, buying securities, and implementing a lending strategy to stimulate the economy. Congress acted swiftly by distributing stimulus checks, unemployment benefits, and supporting businesses. These actions achieved two main objectives: keeping the economic wheels turning and providing support to those most affected by the lockdowns.

A year ago, the main concern was getting the economy stabilized, which, in hindsight, was achieved. According to the Bureau of Labor Statistics, unemployment has fallen from a peak of 14.8% in April 2020 to 5.2% in August 2021 and barring any further nasty coronavirus surprises continues to trend in the right direction. Although full employment has not yet been achieved, when does the Fed change its focus to rising prices?

Combining an economy that appears to be growing with a Fed Funds rate of 0.25% could certainly lead people to wonder if this is too good to be true. All this liquidity in the economy has helped the financial markets, but it is also creating some knock-on issues, with the prime one we hear being, “Why is everything so expensive suddenly?” From groceries to automobiles (both new and used) to the surge in home prices, price increases have left some consumers flabbergasted.

Both the Fed and the markets are pricing in transitory inflation: prices are high right now but should trend back to normal over the coming years. One example is that the increase in automobile prices is being driven by a global microchip shortage (you might be surprised by how much our supply chain in all areas relies on these little silicon wafers) and that rental car companies have needed to restock their fleets which they sold off during the initial phases of the lockdown at the same time production has slowed. Home prices have surged in the last year as well; driven by a combination of people moving out to the suburbs due to new work from home policies, and reduced interest rates. Although far from ideal, theoretically these price shocks will eventually subside as new vehicles are produced, and people return to the office.
   
The chart above shows the levels of inflation for: all items, food, new vehicles, and used cars and trucks from February 2020 to June 2021.

We believe that the Fed is closely looking at its impact on inflation, but fiscal policy is also a large contributor to potential inflation as a lot of stimulus has been passed in the last year. With a $1 trillion infrastructure bill (to give you an idea of how much money $1 trillion is, it is about $3,000 for every person in the United States) and a potential $3.5 trillion budget reconciliation bill on the horizon, fiscal spending has been extraordinary.

Loose monetary policy and enormous government spending are accelerators of inflation; however, there are some important decelerators that need to be considered. New variants of the coronavirus are a disruptive threat to economic growth. Whether through government mandate or just consumers showing hesitancy to reenter their pre-pandemic spending patterns, an overheating economy is not a forgone conclusion.

Something to remember is that news is coming out every day that can cause investors to lose focus on the long-term. It is important to digest this information without overweighting the newest, most fantastic data being published. The price of lumber, which doubled year-over-year several months ago, has plummeted back to pre-pandemic levels. Why? People cut more trees down to meet the market needs. We do not believe that the inflation toothpaste is out of the tube at this point, but if fiscal and monetary authorities squeeze too hard, the work of getting it back to acceptable levels will not be enjoyable for anyone.

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