Everything You Ever Wanted to Know About Inflation but Were Afraid To Ask

Question:   Why does the Fed say inflation is “transitory” while the price of everything I buy is going up? 

Answer:  The Federal Reserve (Fed) officials don’t disagree with you that inflation has picked up. They focus on an inflation rate that is likely different than what you experience as your personal rate of inflation when setting monetary policy. That’s where the confusion arises when an average inflation rate is used for policy, versus what we as consumers experience in the market place. 

In August 2020 The Fed officially revised its monetary policy framework to use an average inflation-targeting system. The Fed’s legislated dual purpose is to influence price stability and   encourage maximum sustainable employment. It defines price stability as 2% inflation as measured by the Core Personal Consumption Expenditures (PCE) Price Index. For the last several years we’ve seen inflation below that 2% long-term target. The recent policy change allows the Fed to pursue a period of inflation moderately above 2%, while leaving the longer-term goal intact. The change reinforces the concept that 2% is a goal, rather than a cap on inflation. The Fed isn’t focused on the price of a single good or service. 

As consumers, we tend to notice price increases right away, particularly for food and gasoline. The Fed takes into account the price of food and energy in its inflation outlook, yet   since food and energy prices tend to be volatile, economists focus on the core inflation measure to follow underlying trends in inflation. This is why excluding food and energy prices remains the most common way government measures inflation. 

For the twelve months ending May 2021, inflation was clocked at 5.0%. The Fed believes this is due to transitory factors, one of which is due to the fact that inflation was low during last year’s lockdowns with the Consumer Price Index (CPI) up just 0.1% for the 12 months ending May 2020. As the economy reopens, it’s evident that prices are rebounding.   

Supply chain disruptions, material shortages, and strained foreign trade resulting from container shortages and higher shipping costs place further pressure on the reopening process. This occurs in every economic recovery; the differences this time are the speed of the economic recovery, labor shortages, unprecedented fiscal stimulus, and the quick arrival of vaccinations, all catching producers off guard. 

Shortages in many areas could last beyond this year continuing to put pressure on prices, driving inflation higher. Labor market shortages and wage friction is more intense than in past economic recovery’s as well. Matching millions of unemployed workers to available jobs is challenging. Schools and daycare facilities will reopen in the fall, which should increase labor force participation.  However, many older workers opted for early retirement and may be reluctant to reenter the labor force.

The increase in household savings, built up during the pandemic, should support consumer spending growth in the near term, but will diminish over time. More moderate economic growth in the future is expected to reduce inflation pressures over time. 

As inflation expectations rise, workers are more likely to demand higher wages causing businesses to try and raise prices, making higher inflation expectations a self-fulfilling prophecy. Some economists are concerned that fiscal stimulus funds will boost demand high enough to outpace supply, pushing inflation even higher. Biden administration economists disagree, believing that supply chain issues will be resolved, and inflation expectations will remain well-anchored.

Inflation is defined as too much money chasing too few goods and services. The aggregate money supply has increased dramatically. M2, which is the most liquid form of money (currency, savings and checking accounts, small time deposits, and retail money market funds), rose sharply in the early part of the pandemic and continues to move higher. 

Households have increased their savings and banks have been accumulating reserves (which the Fed now pays interest on). Bank reserves only become inflationary if consumers borrow excess reserves from the banks and spend. That’s not happening. If higher inflation is sustained, the Fed can always reduce the pace of asset purchases or raise short-term interest rates. This would slow economic growth. Soft landings are difficult.

The Fed will closely monitor the incoming data. There is a risk that what seem like transitory inflationary pressures could be with us for some time into the future. As we wait and watch, Ray Dalio, a well-known investor, succinctly reminds us that “there are two main drives of asset class returns; inflation and growth.” Stay focused and plan accordingly.