Inflation is a stranger to many. In 2011 I wrote a Quarterly Report article about how hard it was to actually have inflation. Yet here we are. The Consumer Price Index (CPI) was up 5 percent in May and the Producer Price Index (PPI – wholesale prices) was up 6.2 percent in April. Anecdotally, things like lumber are up 252 percent.
Why has inflation suddenly returned, and what can we, as investors, do about it? The answer to the first question is interesting. For years we have believed that inflation was caused by loose monetary policy, including very low interest rates and the printing of dollars. The idea is simply that inflation is really a loss of value in the dollar as opposed to an increase in value of goods and services purchased with dollars. In 1995 a gallon of milk cost $2.52, according to research from the University of Wisconsin. According to the USDA the average price of a gallon of milk in May 2021 was $3.60. The idea of inflation being a monetary policy issue means that a gallon of milk is a gallon of milk. The actual value of milk has not changed; what changed was the value of the dollar. Today a dollar is worth less than it was in 1995.
This is how we have long understood inflation. For three decades now we have had loose monetary policy and while this brought us such wonderful events as the dot-com bubble and the financial crisis, it has not actually caused overall inflation as so many have feared. Perhaps there is something we missed?
That 30-year period was marked by the victory of so-called “supply-side economics.” Another way of looking at prices is through the economic law of supply and demand: the price of a product is determined by the supply of that product relative to the demand for the product. If the supply is high and demand low, the product will cost next to nothing. If the supply is low and demand high, then the price will be very high.
In the 1960s and 1970s economic policy was dominated by the thoughts of John Maynard Keynes, who believed that government could stimulate aggregate demand, and that the increase in demand would in turn lead to an increase is supply and overall economic growth. In practice it led to low growth, high inflation, and high unemployment. In fairness to Keynes the man, what politicians did in his name was not exactly what he intended; having studied Keynes I personally believe he would have changed his mind (which, like all truly great thinkers, he often did) had he lived to see the results of policies that bared his name. Unfortunately, we will never know.
In the 1980s the Austrian school of economic thought overtook Keynes, believing government should largely get out of the way. In doing so it would make it easier for businesses to make their products, therefore stimulating supply directly. It was coined supply-side economics. Like with Keynes before, what some politicians proposed in the name of supply-side economics would not exactly hold up under scrutiny, but still as a whole this theory had served us well.
As the supply side of our economy grew, prices naturally would level out if not even drop. We have seen this especially in the technology sector over the last few decades. This phenomenon helped to keep overall inflation at bay even as we experienced loose monetary policy and solid economic growth.
This year we have made a dramatic shift towards demand-side economics and large fiscal stimulus, most notably by paying people bonuses not to work, and of course direct stimulus checks. Simultaneously, we are not just ignoring supply but attacking it. It is hard to increase the supply of products when one cannot find people willing to work to make said products. While much of the remaining attack is in the discussion phase, even threats of increased regulation and taxes has an impact on those who provide the supply of goods and services.
With supply remaining low, demand has been increased and right on cue, inflation is back. The Fed continues to say it is transitory. What they mean is that they believe the increase in demand will stimulate growth in supply and all will be good. I hope they are correct, but the folks who believed this in the past never were. Inflation may be here to stay until we re-learn our basic economic lessons.
In the meantime, what is an investor to do? In the shorter term the market is likely to go sideways as it figures all this out. For long-term inflation protection, nothing beats stocks; as prices rise, so do nominal profits and therefore stock prices. The place to avoid is fixed income, where yields below 2 percent mean that an investor is actually losing purchasing power as inflation rises at twice that rate. We remain cautious and will keep looking at inflation. Will it be transitory or is it here to stay? The Fed says one thing and history tells us another. We hope the Fed is right, but we are not counting on it.
Chuck Osborne, CFA