The Great Inflation Debate
Published on May 17th, 2021
The S&P 500 declined 4.0% from May 10 to May 12, the largest three-day selloff in five months. The Nasdaq composite declined 5.2% and the Russell 2000 index of small capitalization stocks declined 6.0%. We believe investor concerns about inflation sparked the pullback.
On May 12, the U.S. Bureau of Labor Statistics reported that its widely followed Consumer Price Index increased 4.2% in April as compared to the year ago period.1 The CPI increased 0.8% as compared to the prior month, seasonally adjusted. These price increases were higher than expected.2 They were also an acceleration from the growth rates reported in March. The annual increase was the largest in twelve years.
Investors had been bracing for higher inflation to show up the data. One reason is that prices in the year ago comparison period were depressed by the pandemic, a phenomenon known as the base effect. But growth in the April price index as compared to the prior month also accelerated, which cannot be attributable to the base effect.
Most observers believe that inflation is picking up in the U.S. The great debate is whether this increase is transitory. Investors and policymakers typically pay little attention to one-time changes in the price level. But a persistent inflationary environment can be pernicious. It can grow out of control if left unchecked, eroding both consumer purchasing power and corporate profitability. It could weigh on the U.S. dollar, reducing the allure of the U.S. capital markets for foreign investors. And if monetary or fiscal policy is tightened to address runaway inflation, it could choke off the economic recovery.
We divide the current drivers of inflation into three categories. The first is the post-pandemic economic reopening. In April, airline fares increased 9.6%, hotel room rates increased 8.1%, and car rental rates increased 82.2%.1 These were driven by the base effect as prices were depressed a year ago. We expect travel and similarly impacted service industries to increase supply and catch up with demand in the coming months, suggesting this category is likely a source of transitory inflation.
The second category is the knock-on effect of supply chain bottlenecks. Winter Storm Uri shut Gulf Coast chemical plants in February. The Suez Canal was blocked for six days in March, distorting global trade flows. A fire at a Japanese semiconductor plant in March exacerbated a pandemic-induced chip shortage. We believe events like these contributed to a 21.0% increase in used car prices in April, as supply chain constraints prevented automakers from sufficiently replenishing new vehicle inventories at dealers, increasing the value of used vehicles.1 While there is a litany of supply chain issues, we expect most to be resolved in the coming months, suggesting this is another source of transitory inflation.
The final category is labor cost inflation. We believe this is the area of greatest concern, because wage increases tend to be sticky, and increasing labor supply may be more challenging than other inputs to production. Recently there have been signs that labor supply has not kept up with demand. On May 11, the Bureau of Labor Statistics reported that U.S. job openings in March reached 8.1 million, a record level.3 This occurred despite surprisingly anemic nonfarm payroll additions of 266,000 in April, also reported by the BLS on May 7.4 The increase in average hourly earnings in April was a meager 0.3%, but that is because a pronounced mix shift toward lower-wage workers masked more rapid wage inflation within categories.4 The tight labor market may have manifest itself in the 3.6% increase in restaurant prices recorded in April, as labor is the largest expense item at most restaurants, and, unlike other reopening beneficiaries, this category did not see price compression in the year ago period.1,5
Several unusual factors are coming together to suppress labor supply. Fortunately, these may be addressed in the coming months. Some able workers have left the labor force due to fear of contracting or spreading infection. But additional vaccine distribution, the steady reduction in new Covid cases since mid-April, and the May 13 relaxation of guidelines by the Centers for Disease Control and Prevention may give these workers the confidence to return to employment.6 Others have left to care for children, as about half of U.S. school districts remain in hybrid instruction mode.7 This could improve in the coming weeks as schools close for summer vacation and households with children transition to fully in-person options like day care or summer camp where necessary. Generous unemployment insurance may provide an incentive for some workers to remain unemployed.8 While the $300 weekly Federal Pandemic Unemployment Compensation benefit expires September 6, many states are reacting to the possible disincentive to work by ending it earlier, removing another potential obstacle to labor supply growth.9
Recent comments by Federal Reserve committee members suggest the central bank leadership continues to view the recent pickup in inflation as a transitory development.10 We believe these comments have helped to calm the capital markets in recent days, as they indicate the Federal Reserve is unlikely to respond to the recent inflationary data releases by tightening monetary policy. This is consistent with the long-term policy framework revision the Federal Reserve adopted in August, in which it targets an average inflationary level of 2% over time.11 Under its revised framework, the Federal Reserve may aim to respond to persistent disinflation as occurred over the last ten years by engineering an overshoot, or price gains moderately above the average 2% target for some time.
Our point of view in the great debate is aligned with the Federal Reserve: We believe the recent pickup in inflation is likely to be transitory. That said, there are of several types of disconfirming evidence whose emergence might give us pause to reconsider. If CPI and other inflation measures continue to exceed expectations, and the sources of inflation broaden to include larger and stickier components of household spend, such as shelter and health care, it would suggest that inflation may persist. In the labor market, if job openings remain at record levels, nonfarm payroll additions stagnate, and wages accelerate, we would fear a pernicious wage-price spiral taking hold. In the capital markets, the forward inflation curve implied by Treasury Inflation Protected Securities remains inverted.12 If a selloff in long-term TIPS flattened the curve, removing the inversion, that would suggest fixed income investors are anticipating a prolonged inflationary period.
If investors fear inflation will persist, we believe they will favor value stocks, and interest rate sensitive stocks, such as banks. This was apparent in the three-day selloff, as value outperformed growth, and banks outperformed the broader market.2,12 Over the last year, we have been gradually repositioning our equity portfolios to benefit from the reopening trade. This included a shift toward value and interest rate sensitive stocks. Therefore, we are already somewhat prepared for a more sustainable inflationary environment. However, we also added to cyclical exposure as part of our reopening thesis. These stocks could be vulnerable should investors worry that tighter than expected monetary and fiscal policy could slow economic growth or even spark recession. From May 10 to May 12, the Russell 1000 Value declined 3.3%, the Russell 1000 Growth declined 4.8%, the BKX bank index declined 2.9%, and the S&P 500 declined 4.0%.
In our fixed income portfolios, we have been positioned for rising interest rates for some time. This includes holding a shorter duration than our benchmark, which reduces the portfolio’s sensitivity to rising rates. We have also invested in fixed-to-floating rate securities, which may hold their value or even appreciate as interest rates rise. In addition, higher interest rates enable us to invest the funds from maturing securities into higher yielding replacements, generating more income over time than would otherwise be possible, without taking on additional risk.
1Source: U.S. Bureau of Labor Statistics. Consumer Price Index Summary. May 12, 2021.
2Source: Bloomberg and Roosevelt Investments.
3Source: U.S. Bureau of Labor Statistics. Job Openings and Labor Turnover Summary. May 11, 2021.
4Source: Bureau of Labor Statistics. Employment Situation Summary. May 7, 2021.
5Source: Wall Street Journal. Some, But Not All, of the Price Jump is Transitory. May 12, 2021.
6Source: U.S. Centers for Disease Control and Prevention. Interim Public Health Guidelines for Fully Vaccinated People. May 13, 2021.
7Source: Davidson College. Return to Learn Tracker. May 14, 2021.
8Source: Wall Street Journal. More States to Reject Extra $300 Payment for Unemployed. May 11, 2021.
9Source: Wall Street Journal. Fed’s Clarida Surprised by Inflation Report, But Stresses Need to See More Data. May 11, 2021. Fed’s Waller Says Inflation Jump Likely Temporary, Urges Patience. May 13, 2021.
10Source: Federal Reserve. Federal Open Market Committee Announces Approval of Updates to its Statement on Longer-Run Goals and Monetary Policy Strategy. August 27, 2020.
11Source: Federal Reserve Bank of St. Louis and Roosevelt Investments. On May 14, 2021, the TIPS implied five-year breakeven inflation rate was 2.68%, which was greater than the five-year, five-year forward inflation expectation rate of 2.34%.
12From May 10 to May 12, the Russell 1000 Value declined 3.3%, the Russell 1000 Growth declined 4.8%, the BKX bank index declined 2.9%, and the S&P 500 declined 4.0%.