Updated: Jul 29, 2022
By Chris Bardos CFS®, MS in Economics
Co-Founder, Partner and CFO
For most of the last decade, we have enjoyed lower than average inflation and a rapidly expanding economy. Having interest rates near zero, allowed the economy to roar back following the ‘Great Recession’. However, the length of a business cycle is always an unknown and many factors can contribute to the business cycle, one being inflation.
Simply put, inflation is the increase in the prices of goods and services over time reflecting a decrease in the purchasing power of money. It cannot be measured by an increase in the cost of one product or service, rather it is a general increase in the overall price level of goods and services in the economy. Inflation is generally measured by the Consumer Price Index (CPI) (1) as well as the Producer Price Index (PPI) (2).
Presently we are experiencing the highest inflation in 41 years with the most recent reading of the PPI at an 11.3% increase year over year for the 12 months ended June 30th. The CPI is also at its highest level since December 1981 with a year over year increase of 9.1% for the 12 months ending June 30th.
How did we get here?
We can trace the seeds of the current inflationary environment to the beginning of the pandemic in early 2020. As government shutdowns took hold and nearly 47 million people lost their jobs, we experienced huge changes in monetary and fiscal policy. Monetary policy (3), which the Federal Reserve (4) controls by the level of short-term interest rates, changed in 2020. We saw the Federal Reserve reduce these rates from 1.5-1.75% down to 0-0.25% in just eleven days between March 4 and March 15th 2020. Essentially, the cost of borrowing became next to nothing. At the same time, legislators through fiscal policy (5) ramped up government spending via various new programs. The first being in 2020 with the Coronavirus Aid, Relief, and Economic Security (CARES) Act. Months later, the Coronavirus Response and Consolidated Appropriations Act passed. Then again in 2021 the American Rescue Plan passed. This injected over $6.4 trillion into our economy and dramatically increased the M2 Money Supply (6), which is about 42% higher from pre-pandemic levels.
Even with a large injection of cash into an economy, things can continue to expand and grow. However, if problems persist in the supply of goods and services, this is where an economy can find a hurdle. Which, is what we have seen. Many factors have been detractors in the supply chain such as:
1. Continued lockdowns in significant areas of manufacturing like in China, for example.
2. Additionally, here in the US, the labor market has continued to have difficulty finding workers, where there are about two jobs for every seeker, currently.
3. An increase in commodity prices, which were already increasing ahead of the war in Ukraine sparked by the Russian invasion.
This is not a limiting list of factors but some of the main ones that have disrupted the supply chains and have the potential to pinch corporate margins. In summary, compared to the months leading up to the pandemic, we now have a lot more cash flowing through the economy, and too few goods and services to meet the demand.
What’s the path forward?
Inflation affects every consumer and business in an economy however; it hurts those on a fixed income or the lowest earners the most. Therefore, it is part of the Federal Reserve’s job to try to maintain slow and steady growth instead of letting an economy run away downhill like a snowball. With that, the Federal Reserve has taken a stance that inflation needs to be tamed and has committed to doing so. As we discussed earlier, the Federal Reserve controls the Monetary Policy, and is now doing the reverse of what they did in the early weeks of the pandemic, raising the short-term rates, instead of cutting. In March of this year, the Federal Reserve had their first rate hike of 0.25%, since then they have completed an additional 0.50% hike and another 0.75% hike at the June meeting.
At the same time the Federal Reserve is undergoing a shift in now hiking interest rates, it is shrinking its $9 trillion balance sheet in an attempt to extract money from the economy. By pulling back on the liquidity, which was provided to markets, their hope is that prices will moderate and inflation gets back under control. However, hurdles remain such as continued supply chain bottlenecks, a tight labor market, and the beginning of a deglobalization of economies due to the Russia/Ukraine war and continued tensions with China among others. The decoupling of economies (deglobalization) may be the most difficult of these to overcome as globalization has been a deflationary force in the past. It creates an environment of competition whereby capital is allocated in a more efficient manner. Increased trade (globalization) has acted to reduce labor and materials costs for the last several decades which has helped to reduce inflation. With our world changing to reflect more protectionism, a lack of competition can ultimately lead to higher prices.
The stated goal of the Federal Reserve is to engineer a ‘soft landing’. This is where they are successful in reducing inflation (through an increase in short-term rates and balance sheet reduction) without throwing the economy into a recession (7). They have stated that they are more concerned about getting inflation under control than they are worried about putting the economy into a recession. Recession is often thrown around as a headline scare tactic by modern media; however, it is a completely normal part of the business cycle. Economies expand and contract as part of a normal cycle and recessions are typically good for realigning misallocated capital, such as the dotcom bubble when some were being frivolous and buying into anything and everything including companies that had little to no actual product or services.
How can investors manage during this economic period?
1. Control, what you can control.
First, make sure that you are taking an appropriate level of risk with your portfolio. Are you comfortable with your current level of volatility? How does my current investment strategy align with my goals? Historically, having a portion of your portfolio that is in equities that can control future pricing power, helps to combat inflation over the long-term. Talk with your advisor about how you can control the range of outcomes within your investment strategy.
2. Take advantage of potential opportunities.
Asset price fluctuation can allow managers and investors to take advantage of names that have come down significantly in price and believed to be positioned to perform well over a long period of time, therefore consider adding cash that you have been waiting to deploy into long-term investments, if your risk tolerance and plan allows.
3. Keep the long view.
Sometimes it is hard to see the forest through the trees. Think about how far you have come over the last decade with your portfolio. Likely, you have made great progress and have well outpaced the inflation that we have had over that same period, and by a long stride. Historically, market pullbacks have presented great long-term buying opportunities. Remember that when you invest in a stock, you are taking part ownership in the long-term cash flows, growth prospects and profits of said company. Companies try their best to fight through all types of challenges and inflation is just one piece of a much larger puzzle.
Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The report herein is not a complete analysis of every material fact in respect to any company, industry or security. The opinions expressed here reflect the judgment of the author as of the date of the report and are subject to change without notice. Any market prices are only indications of market values and are subject to change. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request.
Glossary of Terms:
(1) The Consumer Price Index (CPI) measures the overall change in consumer prices for a representative basket of goods and services over time. It is the most widely used measure of inflation and deflation. It is closely followed by businesses, financial markets, policymakers (Federal Reserve) and consumers. It tracks 94,000 prices monthly to assess inflation for more than 200 categories of products and services. The US CPI basket includes a 33.3% weighting for shelter costs derived from rents and owner’s equivalent rents. It filters out price increases resulting from product improvements. Some of the broad categories measured include, food, energy, apparel and services. Core CPI excludes the volatile food and energy components.
(2) The Producer Price Index (PPI) measures the change in the prices paid by producers. It is a measure of inflation at the wholesale level. Producer prices heavily influence those charged to consumers and vice versa.
(3) Monetary Policy is a set of tools that a nation's central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation's banks, its consumers, and its businesses.
(4) The Federal Reserve is the central bank and monetary authority of the United States. Its goal is to provide the country with a safe, flexible, and stable monetary and financial system. It’s main duties include conducting national monetary policy, supervising and regulating banks, maintaining financial stability, and providing banking services.
(5) Fiscal Policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth. Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government officials.
(6) M2 Money Supply M2 is a measure of the money supply that includes cash, checking deposits, and easily-convertible near money.
(7) Recession A recession is a macroeconomic term that refers to a significant decline in general economic activity in a designated region. This has typically been recognized as two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment.