Inflation – Here to Stay?

| April 5, 2021 | 0 Comments

The single greatest question facing investors at the moment is what will happen to inflation. This was highlighted with the grounding of a large freighter which recently blocked the Suez Canal, cutting off shipping between Asia, Europe and the U.S. East coast.

Inflation affects interest rates and interest rates affect just about everything else. So this is not a trivial question. It’s also important to remember that few forecasters are able to accurately predict market and economic changes consistently or accurately. After all, there has been widespread fear since 2009 that federal government deficits and the Federal Reserve’s low interest rates were certain to result in hyperinflation, which clearly hasn’t happened. So with that caveat, here’s my best stab at explaining why it’s important and what may happen with inflation.

Inflation is one of the single most important factors affecting interest rates. This is because the people who lend money are most concerned with getting their money back and how much their money will be worth in the future when they do get it back. This second component is all about inflation and the purchasing power of your dollars in the future.

There is a strong case to be made that inflation will likely be somewhat higher in the coming months. This is because it is measured as the year-over-year change in the cost of things, and the price of oil is a big part of that calculation. A year ago, a barrel of oil cost about $30. You read that right. In March 2020, sellers of oil had to pay people to take it off their hands because the global economy was in free fall and there was too much oil available.

Today, oil is selling for about $60 per barrel. That alone will mean a large change in the measurement of inflation. Construction costs have also risen due to material shortages and global supply chains are still reeling from the combined effects of the global pandemic and U.S. trade spat with China. So there will be higher inflation this year. The question for investors, then, is whether inflation remains higher or drops back down to around the two percent level where it has been for the past decade or so.

That will largely depend on the labor market. Sustained inflation can really only happen if people have the money to pay the higher prices. That requires steady jobs and, more importantly, the ability of workers to demand higher pay. In theory, low unemployment should lead to higher inflation, but that hasn’t been the case since at least the 70s. Even with record low unemployment in 2019, there was little evidence of upward pressure on wages, particularly among the lowest income workers.

Over the past few decades, globalization has also helped to bring down prices as manufacturing moved from high cost developed countries to lower cost locations like China and Bangladesh. As labor costs rise in those places, there are still other locations for labor-intensive production to go to keep costs down. One factor that may begin to reverse this trend is a push to bring production back to the U.S. The shortage of masks and gowns early in the pandemic and the more recent shortage of computer microchips for automobiles highlighted the hollowing out of U.S. manufacturing capacity. An effort to bring this production capacity back to the United States may cause a gradual increase in prices, but this will take a long time to be felt by consumers.

Getting back to the question of inflation, the Federal Reserve has indicated it will keep interest rates low until they see signs of full employment and rising prices. That means that short-term interest rates (like those on savings accounts and money market mutual funds) should be low for some time. Longer-term interest rates have been rising, signaling investors are expecting higher inflation, but so far nothing indicates expectations of runaway inflation or even much higher than two percent or so we’re used to over the next few years.

So we should see some higher prices this year as the pandemic eases and supply chains sort themselves out, but without significant gains in wages, inflation shouldn’t be a problem the coming years.

This column is prepared by Rick Brooks, CFA®, CFP®. Brooks is director/investment management and an owner of Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at Brooks and his family live in Mission Hills.

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