FeAture
Blast from the past: Inflation
Issue 3
July 19, 2021
By Chris Kuehl
Remember “grunge”? Did you once sport a look featuring Doc Martens, dark flannel shirts and torn jeans while listening to Pearl Jam and Nirvana? If so, you are right in style for the return of 1990s economics. It really has been almost twenty years since we have had to deal with anything approaching real inflation and now it has once again reared its very ugly head. There are many people in business that have never really encountered an inflation spike but they are learning all about it now.
There are three pillars as far as inflation is concerned. At this point one of the three is generally a total non-factor and nothing to be remotely worried about at the general economy level but it has been affecting certain sectors such as manufacturing, construction and transportation as these have been sectors that have been dealing with labor shortages for years. One of the inflation drivers has been making an aggressive push already and the third could be playing a major role by the end of the year. The real questions are how long this threat lasts and how bad will it get.
First pillar
The most minor impact thus far is felt in terms of wage inflation but that is a reference to overall employment and is not all that descriptive as far as the industry is concerned. The massive employment meltdown due to the pandemic took the unemployment rate as high as 15 percent for awhile and a year later the rate is still high at just over 6.0 percent. The rate in February of 2020 was down to 3.2 percent but even then, there were issues in many sectors. Labor shortage has been an acute problem for many years and this persistent shortage of qualified and trained workers has meant that higher wages and more generous benefits have been paid out to recruit the needed people and to keep them. The fact that millions of service sector workers lost their jobs did nothing to alleviate the labor shortage in manufacturing, construction, transportation and other skilled areas. The long and short of it is that many businesses have indeed seen wage inflation.
Second pillar
The second pillar of inflation has been abundantly obvious and has slammed the economy extremely hard. Commodity inflation has been aggressive for months and the prices keep getting higher. Oil prices languished in the $30 to $40 range for the first half of 2020 but that pattern started reversing even before the end of the year. Now prices are in the mid to upper 60s consistently and have been as high as the 70s and even 80s. This ratchets up all commodity prices that are linked to the oil sector. The higher prices arrived as demand started to make a recovery and while many of the oil producers continued to reduce output. The oil sector was stung by the sharp drop in demand that came with the pandemic lockdowns and wanted to work that surplus off. Now they are starting to adjust production to match demand but very slowly. How high will the per barrel prices rise? The fact is that oil producers do not want to see prices much above that $80 range as this level of pricing invites a lot of marginal producers to get into the system and that tends to erode market share for the more dominant producers. There are events that could temporarily drive the price up but the expectation is that prices will stay in that range between $65 and $75 a barrel for the bulk of the year.
It is not just oil that has gone up. Most of the other commodities have been pushing new highs as well. Steel prices and other metal prices are up as well as a variety of building materials such as lumber. The Big Freeze in Texas had a very serious impact on refinery operations there. For the most part commodity driven inflation is temporary as long as there is ample competition and as long as demand does not get carried away. There is still concern that demand will spike beyond what producers anticipate. The consumer has more than $5.4 trillion in savings and that is close to a record. This is all money that can come off the sidelines in the months ahead and that could spark enough demand to overwhelm cautious suppliers.
Third pillar
This brings us to the third pillar of inflation – that money supply. The fact there is $5.4 trillion out there waiting to make an appearance is a good thing to be sure. It means that people have the money to buy things and polls suggest they have the desire. One of the prime barriers to that rush of spending has been the pandemic and more specifically the lockdowns that have come as a result of trying to control the spread. At the time of this writing about 46 percent of the US population had been vaccinated – about 50 percent of adults and over 80 percent of seniors. This is still not at herd immunity levels but it has been enough for many states and communities to lift lockdowns and that unlocks consumer spending. Now the question is whether that unlocks too much and too fast. An abundance of cash cascading into the economy all at once may overwhelm the ability of producers to meet that demand and they react by raising prices. This dampens demand a little but frankly the real motivation is that they can hike prices and make more money as it is likely there will be some consumer willing to pay the higher price.
The major boost to the money supply has come from the various stimulus efforts that have been put forth by the government and of those the most important was the first one back in the second quarter of 2020. That was a deliberate stimulus attempt – a traditional recession fighting tactic. The idea is to get as much money in the hands of the consumer as possible and have them spend the economy right out of recession. There was no attempt to target the funds – they were spread as widely as possible to all income levels so that everybody would spend. The problem is that consumers spend about 65 percent of their disposable income on services and that outlet was largely denied them. Some switched and spent on goods but most saved a lot and that money is still out there looking for a place to go.
The next potential boost comes from the potential spend on a big infrastructure effort. The last stimulus was really more of a rescue than a stimulus as this one was targeted at those that had been adversely affected by the recession. It will add some to the consumer rush but not as much as the first one. The infrastructure effort will be bogged down in Congressional wrangling for months and months and will be unlikely to have an impact until 2022.
What makes inflation such a problem?
Beyond the fact that nobody wants to see higher prices – what makes inflation such a problem. The short answer is that higher inflation will provoke a reaction from the central banking community and that includes the Federal Reserve. The current rate range is between 0.0 percent and 0.25 percent. The Cleveland Fed has issued a study that asserts the rate should be between 1.1 percent and 1.5 percent and that would involve at least four or five quarter point hikes in the coming months. The Cleveland Fed is led by Loretta Mester and she is a noted “hawk” as far as rates are concerned. Thus far she is in the minority when it comes to hiking rates and even she has suggested that inflation at the core level would not justify a rate hike at this point. The question is what level of inflation would be enough to trigger a rate hike and how high. For the time being there is not a lot to worry about but the next couple of quarters will bear watching.
New territory
Now that we are dealing with real inflation we have to adjust to a world we don’t really have much experience with. Most of the behaviors we would engage in when facing an inflation threat will likely make the situation worse – buying something now in anticipation of the price going up later. That creates that much more demand and ensures that the price hike happens. It is new territory for most and many remain confused as what course of action to take.
About the author: Chris Kuehl is managing director at Armada Corporate Intelligence and can be reached at chris.kuehl@armadaci.com. He is the author of the Business Intelligence Brief received daily by KyCPA members.