For most of the twenty-five years prior to 2020, low inflation was the norm in the US (and in most developed economies). PCE* inflation, the Fed’s preferred measure for inflation, spent most of that time below 2%. In fact, in the aftermath of the Great Financial Crisis (GFC), deflation was the chief worry of policymakers. Other factors that contributed to the exceptionally low inflation data include:
- Globalization, which allowed businesses to reduce costs by sourcing labor and materials abroad;
- Slow GDP growth, particularly after the GFC since financial crises result in more sluggish and gradual recoveries which made it challenging for businesses to raise prices;
- Less investment spending by businesses following the GFC, which also kept GDP growth in check;
- Credibility of the Fed as an inflation-fighting central bank, which fostered low inflation expectations and became a self-fulfilling prophecy until 2021;
- New business models exemplified by Amazon which intensified retail competition and put real-time pricing information in the hands of consumers like never before.
Fast-forward to today: inflation in the US has hit its highest level in more than three decades following a global pandemic that continues to rage in parts of the world. The pandemic brought more tectonic shifts:
- The ability to work from home led many to make life-altering changes: upgrading homes, moving to more tax-friendly states, changing careers, retiring early, and other personal decisions that are still not fully understood;
- Spending on goods expanded as many consumers had more time from the reduction in commuting, and higher discretionary income from government stimulus checks;
- Shut-downs that suddenly gummed-up intricate supply chains for a myriad of goods and services (which continues today);
While it may seem that high inflation is here to stay, there is some hope that inflation will soon revert to lower levels. First, research from Deutsche Bank suggests that wage growth tends to lead productivity growth. Why is this important? Productivity growth is critical to keeping inflation in check. Without getting too dense into economic theory, the premise holds that higher labor costs incentivize employers to adopt labor-saving, productivity-enhancing measures. Some of these could involve the use of technology, others could involve simply reducing the services offered (ordering a restaurant meal by QR code, for example), or perhaps some combination of the two. The point here is that recent wage inflation should lead to higher productivity which lowers the overall inflation rate, which in turn should begin to reduce inflation expectations across the economy.
These types of changes are emblematic of a myriad of changes that take place in reaction to price increases, all of which ultimately lead to the rate of inflation coming back down.
Another signal that inflation is near its peak comes from the New York Fed’s Underlying Inflation Gauge (UIG), which incorporates not only the CPI price data but also nominal, real, and financial data. The NY Fed uses a dynamic factor model to calculate the UIG, which means the weighting of each series varies over time. This is important since inflation does affect spending choices in terms of both mix and volume, another way that inflation is ultimately its own worst enemy.
According to a piece from J.P. Morgan, research from the NY Fed finds that “the UIG significantly outperforms other core measures when forecasting headline CPI. Furthermore, they write that they ‘view the UIG as providing a strong and reliable signal for an approaching change in trend inflation.’”
The chart referenced to the top shows the most recent UIG data from the NY Fed: the blue line appears to be plateauing, which is another encouraging sign that the worst may be behind us.
A common saying in the field of economics is that higher prices are the cure for high prices. In essence, the research from Deutsche Bank helps prove this point. A dynamic economy like the US will result in changes on the part of consumers, businesses, and governments that will ultimately bring about lower inflation. Of course, nothing happens overnight and all of this change will take time, but it is very likely already occurring. The most recent retail sales report revealed some shifts on the part of consumers such as trading down to store brands for some grocery items, and consumption patterns are likely shifting in ways that will lay the foundation for lower inflation.
Our advice: Don’t pop the champagne yet. In fact, if you haven’t bought the champagne yet, buy prosecco instead — it’s less expensive and still sparkles! The transition that will lead to lower price inflation is in place and the results will take time to be fully reflected, but inflation will not remain at current levels indefinitely.
*PCE inflation is the Personal Consumption Expenditures Price Index, the Fed’s preferred measure of inflation since 2012. It uses prices from all households, corporations, and governments into account, along with GDP. The index is weighted by data acquired through business surveys, which tend to be more reliable than the consumer surveys used by the CPI. It also uses a formula that allows for changes in consumer behavior and changes that occur in the short term. These adjustments are not made in the CPI formula.
Sources:
US Economic Perspectives, Deutsche Bank, October 10, 2018
Myriad measures for quantifying core inflation, J.P. Morgan, November 17, 2017
Federal Reserve Bank of New York, newyorkfed.org
Maple Capital Management, Inc. (MCM) is an independent SEC Registered Investment Advisor with offices in Montpelier, Vermont and Atlanta, Georgia. This commentary reflects the views of MCM and should not be considered to be investment or financial advice. MCM does not warranty these views and will not update this communication after the date of publication. Any mention of specific securities is done for illustrative purposes and the securities mentioned may or may not be held in client accounts. No assumption or assurance should be taken that securities mentioned will be safe or profitable investments. For further information, please contact Steven Killoran at 1-802-229-2838 or at [email protected]. For further information about Maple Capital, including a copy of our informational brochure, please visit our website at www.maplecapital.com.
