Is Inflation Here To Stay?
For the large part of the year, the markets have been watching very closely for any new inflation data point. The consensus is that we will experience higher than usual inflation and that most data points released over the next couple of months will be higher than usual. The reason is simple; most of the inflation data compares year-over-year movement, and last year in the second quarter the economy was mostly shut down.
The real question is whether inflation will be transitory or if it will it persist longer and get out of control. The Federal Reserve believes inflation will only be temporary, but some market participants do not agree.
Economic theory tells us inflation can happen from two sources. The first way is demand-pull inflation, which is where aggregate demand is greater than aggregate supply in an economy; in other words, people are buying more things than are available. The second way is cost push inflation, where there is a decrease in the aggregate supply of goods and services because of an increase in the cost of production. For example, increase in commodity prices or labor cost.
We are going to show a series of charts to help answer the question, is inflation here to stay?
The chart below shows the Consumer Price Index. The May figure was released on Thursday, and it came in at 5% year-over-year growth. The markets expected a jump in the figure, and it shrugged off the data point as the broader indexes closed higher on the day. As we stated earlier the consensus is that we will see higher inflation in the near term.
The following chart begins to provide insights on demand-pull inflation. It shows the M2 Money Supply, which is money people have in their checking accounts, savings accounts, and money market accounts. In other words, money people can easily use to buy goods and services. The chart shows a big increase as a result of the fiscal and monetary response to the COVID-19 environment.
However, in order for all that money to begin to cause inflation, it has to be spent. For a gauge on how much money is making its way to the economy, we look at the Velocity of the M2 Money Supply. As the chart below shows, the velocity of money has been decreasing for some time now. This leads us to conclude that even though there has been a large increase in the M2 Money Supply, it is not making its way into the economy, and therefore, demand-pull inflation is unlikely.
Turning now to cost push inflation, we will focus on commodity prices and labor cost. For commodity prices we will look at the S&P GSCI Commodity Index, which is a broad-based index that tracks prices of Agriculture, Energy, Industrial Metals, Livestock and Precious Metals. Looking at the chart below, we can see that commodity prices have been spiking higher, but by no means is it at extreme levels. The chart shows that, from the period of 2011-2014, this index was higher than where it is today.
Viewing the labor market graph, we can easily see that the unemployment rate jumped up as COVID was unraveling and now it has been coming down quickly. The argument people make is that labor cost will lead to inflation as people make their way back to work. However, looking at the chart closely, we see that the unemployment rate was at 3.5% at the start of 2020 with no inflation in sight.
Both commodity prices and the unemployment rate charts lead us to conclude that cost push inflation is also unlikely.
The final chart we will show is the 10 Year Breakeven Inflation Rate that shows what the multi-trillion-dollar bond market thinks inflation will average over the next decade. As you can see on the graph, it was moving higher as the market panicked about inflation in the first quarter. However, that fear is wearing off and inflation expectations are coming down.
Of course, nobody has a crystal ball, and it is impossible to know with 100% certainty how things will play out. However, the data shows that inflation is more likely transitory, just like the Federal Reserve States, and that is why we have kept our conviction in technology stocks even though they pulled back from their February highs. We will continue to monitor the data points as it becomes available, but for now we don’t think inflation is here to stay.