Inflation Becomes a Problem for the First Time in Decades

Accelerating inflation is a phenomenon that many Americans, and those in the developed world more broadly, have little experience. In the 25-year period leading up to the 2020 pandemic, US core consumer inflation, which excludes food and energy, rarely topped out over 2%. As of November 2021, core inflation has since accelerated to an eye-watering 4.58%, marking the highest level since the early-1990s.

US Core and Headline Inflation Rates (%) Core inflation has accelerated to 4.58% in November 2021

Source: U.S. Bureau of Labor Statistics

But what is inflation? Inflation is the rate at which prices increase. Typically, when you see a published rate of inflation, say 2%, this implies that the cost for a good today is 2% higher than that same good a year earlier. Inflation is only a problem when it rapidly accelerates over time. If inflation is 2% today, tomorrow and next year, consumers and companies can adjust, raising wages to account for the steady increase in prices. Indeed, a stable level of inflation is preferred. If inflation is negative, technically referred to as "deflation," prices decline over time, a phenomenon that weighs on consumption as individuals forego purchases until sometime in the future in the expectation that by waiting prices for the same good or service will be lower further out in time. You could theoretically keep inflation at zero, but this provides very little cushion in the case of an economic downturn, which tends to see a short-run weakening in prices. Even during the initial outbreak of Covid-19 and subsequent lockdown orders through April/May 2020, core inflation remained positive despite a brief dip in prices.

Inflation becomes a problem when it accelerates quickly, as has been true over the past eight months. When prices go from increasing at a rate of 2% to increasing at a rate greater than 4%, as has been true across the US core inflation time series, it is very hard for consumers and businesses to adjust. Wages, which tend to lag by six to 12 months, struggle to keep up. In addition, rapid increases in wages can support inflation as workers come into higher amounts of cash, further contributing to the inflation problem. This is especially problematic in our current economic moment, in which many workers are moving jobs and securing higher pay. Average weekly earnings finish November higher 4.8% against year-earlier levels, outpacing pre-pandemic rates of growth by nearly two percentage points. Businesses also have to make difficult choices around how much of an increase in input costs to pass onto the consumer without severely restricting customer interest in a respective product or service. On the other hand, businesses have to weigh the extent to which they can absorb higher costs, which eat into margins and limit profitability.

US Energy and New/Used Vehicle Inflation (%) Energy and vehicle prices have undergone an especially large increase in recent months

Source: US Bureau of Labor Statistics

Clearly, inflation is a problem, but what's causing the recent wave of price increases? The answer is multifaceted, resulting from several factors. First, supply-side constraints are limiting inventory levels and thus, driving up prices. A zero-Covid policy that remains in place in China is limiting global manufacturing capacity alongside a meteoric rise in shipping rates as the consumption of goods, over that of services, puts a strain on shipping capacity around the world. According to the US Census Bureau, the business inventories to sales ratio, which measures the extent to which inventories can cover sales, was reported at just 1.24, the lowest level since the time series began reporting in the early 1990s. This implies that for every $1 of sales, a company has $1.24 worth of inventory on hand. Pre-pandemic, this same ratio was holding at 1.4, an 11% difference. While a low inventory to sales ratio can indicate efficiency, at current levels it likely implies shortages in supply.

Further evidence of a supply-side crunch is via the examination of waterborne freight rates - i.e., the cost to ship goods on a vessel. Deep-sea freight costs, as measured by the U.S. Bureau of Labor Statistics, are up nearly 26% against year-earlier levels. The cost for US general freight trucking (+18% y/y) and rail freight (+8% y/y) were also broadly higher against historical norms. In simple terms, there is not enough carrying capacity to meet the demands of downstream consumers.

Elevated freight pricing is not only a result of supply-side restraints (i.e., limits to carrying capacity) but also a consequence of elevated demand levels, the second point driving inflation higher in recent months. Since the initial outbreak of the pandemic, US consumer demand has accelerated at an unprecedented rate. Through the first eleven months of the year, retail sales finished higher 18.4% against the same period 2020. Even when adjusting for inflation, which removes ~5 percentage points of growth from this figure, retail sales have impressed this year. Much of this retail demand has centered on the demand for physical goods, rather than services (i.e., food service, travel, etc.) as people have chosen to stay at home amid ongoing Covid-19 concerns. The purchase of furniture and home furnishings is a perfect microcosm of this issue - sales of these types of goods are so far up 28% year-to-date, well above growth rates of less than 5% before the pandemic began. This extraordinary goods-centered retail demand not only causes an increase in the outright price but puts an undue burden on the transportation networks meant to ferry purchased items throughout the United States and beyond, adding further upward price pressure.

Outright US retail demand has also been supported by unprecedented levels of US government spending, largely in the form of direct cash transfers. In 2020 alone, fiscal stimulus pushed to historic levels, finishing the year at USD 6.8 trillion, an increase of 50% y/y. Expenditures have remained elevated in 2021, largely as a result of an additional Covid-19 relief bill passed through Congress in March. This has had the effect of pushing US cash savings to near-record highs. In Q3 2021, US time and savings deposits were reported at USD 10.7 trillion, up USD 1.03 trillion against Q3 2019 and off only slightly against the record set in Q1 of this year. In simple terms, this means that Americans have a lot of cash on hand, which has helped to juice consumption. The question moving forward is whether Americans will be willing to draw down on these time and savings deposits, which sit at record highs, but have leveled off in terms of growth in recent quarters. My guess is that spending is likely to slow given weak consumer confidence and the rapid increase in inflation, which could help to ease the gains to inflation somewhat.

What does all of this mean for you? Several key points to takeaway:

  • Ultimately, inflation will remain a problem well into 2022. The Federal Reserve will take an aggressive stance and raise interest rates in an attempt to quell further increases, which will weaken demand and put the brakes on investment, both factors that will weigh on future price rises, albeit to what extent remains an open question.

  • Supply-side disruptions, which are likely to persist into 2023, will remain the central driver of inflation. The extent of future Covid-19 outbreaks and US - Chinese relations will play a central role in any supply chain recovery. The degree to which US consumers are willing to purchase services over goods and draw down on elevated cash savings will also be a key determinant of supply shortages.