There has been an awful lot of talk lately about rising inflation, especially with the Fed’s announcement that they are willing to let inflation run slightly higher than their 2% target to aid recovery. So naturally, everyone starts thinking about $10.00 loaves of bread. But the real question is, should we worry about inflation? The simple answer is, inflation isn’t always a bad thing. This week, we are going to break inflation down and look under the hood. Let’s start with the reasons behind the fears.
What Drives Inflation Fears?
In the current environment, there are a few specific things that are causing concern over inflation.
- An accelerating economy
- Pent-up demand
- Historic fiscal and monetary stimulus
- The Fed’s commitment to maintaining the monetary support until full employment is achieved.
- The Fed’s strategy to allow inflation to rise slightly above their target of 2%
The fears stem from the concern that if inflation gets out of control, the Fed will have to raise interest rates to get things under control. The byproduct of this would be tighter financial conditions. While these are valid concerns, we believe that runaway inflation worries are unnecessary because we think the Fed will cap core inflation at 3% this year. We also feel that they won’t let it get to 3%.
Near-Term Pressures Are Well Contained
One of the things that cause fears is near-term pressure on inflation. Right now, although the US economy has undoubtedly progressed far and quickly, it’s still going to take a long time to get global growth in sync. However, when that does happen, we expect to see inflationary pressure dissipate. The reason behind this is simply the fact that other countries are not in the same place that the US is with regards to the economy and vaccination efforts. Their battle to contain Covid has led to slower economic growth than we have seen domestically.
We also have to consider that not every area in our economy has been a substantial part of the recovery. The best example of this is the service industry which has suffered the most from the pandemic. All that being said, pressures on inflation at home have not been severe, which is what is behind the Fed’s expanded inflation policy.
Forces Affecting Long-Term Inflation
In a nutshell, we believe inflation will stay under control for the remainder of 2021. However, fundamental inflationary forces have been at play for many years. The main factor is that wages are now a more significant part of companies’ overheads than production costs, creating an inverse relationship between them. What this really ends up meaning is that lower unemployment no longer corresponds to wage growth. Production costs are lower, so companies don’t have to raise prices to respond to a tight labor market.
Think back to pre-pandemic times, if you can. Unemployment, at its lowest, was 3.5%. However, the economy still wasn’t hitting the Fed’s target 2% inflation rate. Another factor that contributes to this inverse relationship between wages and unemployment is the aging workforce. As a result of these fundamental changes, long-term growth is just slower than it has been in the past. That isn’t necessarily a bad thing; it’s just a factor at play.
Last but certainly not least is the effect technology has on inflation. Advancements in technology are a good thing in many ways, but they create pretty strong headwinds for cost inflation. In English, that means tech often makes things cheaper. We see this most decidedly in the e-commerce sector. There’s even a catchy little name for it, “The Amazon Effect.”
So, between the inverse relationship between wage and production costs, and the cost minimization that technology has caused, inflation should remain in check for the time being.
In short, there is nothing to worry about. The Fed is doing exactly what it should do, our economy is doing far better than that of other countries, and there are plenty of factors that will keep inflation in check.
LPL Research. Are We on the Brink of an Inflation Crisis?Accessed May 10, 2021.