Inflation: A Mirrage?

Over the past few months we have seen a steady rise in inflation.

The most recent YoY Inflation Rate in the U.S. was 4.2%, the highest since Sept 2008 (hopefully this is not ominous of things to come…🥴). Meanwhile the core inflation rate came in at 3%, the highest in over 25 years. CPI, PPI and inflation expectations are also crawling higher and coming out well above expectations.

Despite Powells insistence that inflation is likely to prove transitory, and that we should not discount the impact of the base effects* from the pandemic lows, the market, the news and the street are rampant with “Money Printer go Brrrr” memes and calls of impending hyperinflation.

Now if the word on inflation is out on the street, as google search trends suggest, looking forward we cannot discount the psychological impact of inflation expectations, for as Friedman suggested, inflation can be a self fulfilling prophecy.

So what is causing the inflation?

Gold bugs, Bitcoiners and other pundit Austrians are pointing to the unprecedented growth in money supply as the root cause, and indeed it is undeniable that M2 has skyrocketed in most countries since the Covid crash in March 2020. And yet, in citing the monetarists, they seem to have forgotten a key point, velocity. Fisher’s very elegant formula stated that MV=PT. Well, the V(velocity) part of the formula is at the lowest level ever recorded since the St Luis Fed started recording the data in the late 1950s. So, at least for now, money printing cannot be the only cause of higher inflation. Don’t forget that Governments have been busy “printing money” for years now** and we have not seen any inflation. That said, with rapid progress being made with the vaccine rollout and the path to a full reopening seemingly around the corner, one can expect the V part of the formula, velocity of money, to pick up speed in the coming months and undoubtedly that would add to the inflationary pressures.

It’s undeniable that inflation is rising.

Over the past 10 months we have seen a staggering rise in commodity prices, with Lumber being the poster child, but Copper, Plastic, Iron Ore, Corn etc all following suit. Inevitably these prices are being passed on to consumers.

From my own experience managing the restoration of a property in Italy, workers in the construction industry are struggling to make quotes as prices keep slipping away from them. The trend is for them to increasingly quote h/work + materials as a pose to previously when they made fixed quoted for given projects. Moreover the cost per unit hour of labour is also raising. Whether the work is invoiced or paid cash, workers are demanding higher compensation, from what I see, and this is a rough estimate, we are talking approx 10/15% more compared to 18/24 months ago.

So what is causing this rise in prices? Is it really just the money printer?

What distributors of materials and the managers of construction companies are complaining about is the lack of supply and the difficulty they are facing in getting hold of materials in the first place (copper and pvc in particular). Moreover, at the same time, they are all swamped with work. Way more than they would ever have expected. Indeed they are scrambling to keep up.

Thus a clearer pictures emerges. Supply chain disruptions and unexpected demand have a role to play in the immediate term inflationary pressures we are seeing.

The government mandated lockdown, which occurred across the globe, forced many producers to shut down their factories or at the very least reduce output. At the same time supply chains faced disruptions, slow downs and increased cost, all contributing to the rise in prices we are witnessing. Furthermore, as cheaper Eastern producers were unable to get product to the West, locals were forced to turn to higher cost domestic producers.

It is reasonable to assume that over time these supply chain issues will normalise and revert back to mean, thus restoring the disinflationary pressures of Globalisation which have been the norm for decades.

Briefly, it is interesting to look into the demand side of the equation, as it has surprised many to the upside. Forced to stay at home and restricted in their consumption of the service and experience economy, many consumers turned their spending power towards the refurbishment and renovation of their homes. Moreover there has been a trend in the movement of people away from the major metropolitan and urban centres towards more rural areas. This has, on top of supporting and indeed putting pressure on the price of homes, increased demand for homebuilding materials. The same trend has been witness in consumer electronics, where people have opted to upgrade everything from their phones, to laptops and televisions, as they become an increasingly import part of their lives. Did anyone notice Apples blowout quarter? The supply chain pressures in this specific area is exemplified by the semiconductor shortage the world is currently experiencing, which according to the CEO of Intel may take up to 2 years to resolve.

And yet we should not forget about the money printer.

Undoubtedly the unprecedented speed and scope of fiscal support offered by government has had a role to play in shoring up peoples spending power. Be that through the unemployment benefits and stimulus checks sent in the US, the furlough schemes implemented in the UK & EU or the loans and grants offered to businesses large and small.

Returning to the construction industry, an interesting case study is the 110% Home Bonus offer by the Italian Government. Put simply the government is offering compensation of up to 110% on home renovation where the house is modernised to meet higher energy efficiency standards. A similar incentive is being offered to make homes more earthquake proof . This has, in the case of Italy, caused a scramble as people try to make the most of the incentives to either renovate their homes or restore semi-abandoned properties belonging to their family. This is a clear example of how the fiscal support offered by government has translated into increased demand and thus intensified the shortage issues caused by the supply chain disruptions.

So, returning to our inflation dilemma, it is clear that in the months of April, May and June of 2021 we are likely to see relatively high YoY inflation prints and the reasons for this can be traced back in great part, even if not exclusively, to: base effects, supply chain disruptions, unexpected high demand in certain sectors of the economy and fiscal spending by governments.

We have already established that supply chains are likely to be restored at some point over the next 6–12 months. Indeed it may be the case that by the time that happens producers and sellers find their inventories over stocked and over supplied, which is clearly going to put pressure on prices as they tried to get rid of stock. At the same time the base effects will disappear as the months move on and it will be particularly interesting to see what inflation data we get come late summer, from July onwards.

The sustainability of demand is an interesting one. As materials prices soar, renovation cost increase and house prices continue to rise those who have not yet renovated or moved homes may chose to postpone that move. On the other hand, the reopening will create a whole new wave of demand and spending in the service economy, something which has been heavily suppressed for over a year now. Feeling the pent up demand anyone?

At the same time the U.S. is planning a huge 4 Trillion Dollar Infrastructure Plan, which one would assume would add even more fuel to the fire. But let’s wait and see on this last one for with inflation pressures mounting, a razor thin majority, and midterm elections getting closer, who knows if and what plan will be passed.

One of the most interesting thing to observe will be wage inflation. If we get wage inflation at the low end of the spectrum that could add an inflationary force which has not been witnessed for years. Wage inflation is an interesting one, expect a separate article to look into this.

Thus, to sum thing up, the real question unnerving many investors is what comes after the summer? How transitory will Inflation prove to be. Until June economist and the Fed will be able to justify high inflation prints by pointing to the base effects, but what happens after that? Will inflation continue to trend higher or will the deflationary forces we have been accustomed to in the past 30/40 years return to haunt us? The reality is no one knows, not even the Fed, and it’s a very hard call to make.

For now, many market participants will be able to brush aside inflation fears, but should inflation persist at these high levels beyond July, well, things might get interesting. Concerns about the Fed having to tighten will intensify and this will put pressure on many areas of the market.

In the next article you will find some thoughts on some of the deflationary pressure which may come back to counterweight short term inflation.

• * YoY inflation is calculated on a 12 month basis, so starting from the depressed data April 2020, of course the April 2021 prints are going to be higher than the average.
• ** It is questionable how much money printing has actually happened, and if QE is indeed money printing, but more on this complex topic in another article.