Inflation: The Was, The Is, and The Will Be
“We’re seeing very substantial inflation.” Warren Buffet, billionaire investor, May 1, 2021
"I don't believe that inflation will be an issue.” Janet Yellen, US Treasury Secretary, May 2, 2021
Inflation: The Was, The Is, and The Will Be
One exercise I like to have investors do is to look back and evaluate historical interest rates and inflation rates compared to recent history where inflation is under 2% and mortgage rates are in the 2-4%/year range. When they see what inflation and interest rates have been historically, they are a bit amazed.
There is increasing concern about the possibilities of inflation. Economists and governments have generally viewed some inflation – around 2-3% per year – as a good thing and a natural response to economic growth. However, high inflation rates (over 5%/year) and spikes of unexpected inflation, can be an economic problem to the government and investors, particularly investors living on fixed income.
As the quotes above represent, there are big players with diverse views about potential inflation problems.
The Was
One of the most common measures of inflation is the Consumer Price Index (CPI) published by the Bureau of Labor Statistics. Reviewing the data you will see that we are experiencing low inflation rates relative to post WW-I (up to 18%/year), post-WW-II (up to 14%/year), the late ’60s (over 5%/year), the late 70’s/early ’80s (up to 13%/year), and even the late '80s/early '90s when we had “modest” inflation in the 4-5% range.
Historical US Inflation (Percent Per Year)
Source: https://www.macrotrends.net/2497/historical-inflation-rate-by-year
The Is
What causes a lot of confusion today is the apparently conflicting data between the changes in prices that many of us are seeing versus the forecasts for inflation as captured by financial markets.
Inflation forecasts are often depicted by the spread in yields between 10-year US Treasury bonds and 10-Year Treasury Inflation-Protected Securities (TIPS). The difference between these two yields is approximately the anticipated inflation by investors. Today, that number sits around 2.4%, which is up from less than 1% last year. Certainly, nothing to cause great concern.1Overall, inflation expectations based on this measure seem muted, making Janet Yellen appear correct in her statement.
So, why is Warren Buffet (and others) concerned? Here are some possible reasons why.
Possible Causes for Inflation Concerns
Inflation - or the expectation of it - can be driven by several factors - individually or collectively. Some of the most influential factors include: increased demand causing prices to rise, increased competition for labor causing wages to rise, and increased money supply causing the value to decline. Let us quickly take a look at these.
1. Price-Driven Inflation
First, we are seeing evidence of “price-driven” inflation across many areas. Some argue (including Ms. Yellen) that this is just a transient, pandemic bounce back and we will return to normal. Yet, what concerns others is that prices in many notable areas are passing pre-pandemic levels2. For example:
Housing prices are increasing at double-digit rates in the US and globally.
Key commodity prices are increasing at high rates:
Lumber is up over 50% in 2021.
Copper prices are at a decade high, and up over 100% since 2016.
Gold, silver, and palladium are all significantly higher over the last few years.
Major agricultural crop prices are above pandemic levels. In fact, the World Bank’s Agricultural price index is at a seven-year high.
Soybean prices are up 80% over the last 5 years.
Corn prices are up 80% over the last 5 years.
Thankfully, coffee prices remain below 2011 highs!
Obviously, these are not all the agriculture prices but there is enough movement to cause some investors to wave the inflation warning flag.
2. Wage-Driven Inflation
Second, we are seeing interesting working conditions in the U.S. that are often indicative of “wage-driven” inflation. Wages have been steadily increasing over the last 10 years and hit a 4.4% growth rate last month. US unemployment has stabilized (still higher than target around 6%) but now companies are having a difficult time filling openings. In response, companies are increasing wages to attract talent. (You can now make $17.65/hour delivering pizzas for Dominos in Colorado!) In many cases, companies are competing against (temporary) generous government incentives to not work.
While not all wages are increasing, and there is much debate here, upward pressure is being applied.
3. Money Supply-Driven Inflation
Third, “money supply-driven” inflation has become a concern. The US government is spending at record levels to stimulate our economy. And they’re using record levels of low-cost debt in the process. Economists raise two essential groups of questions around these spending and borrowing patterns.
How much stimulus is necessary, and could the economy possibly be overstimulated and pushed into an inflationary environment?
Given the increasing level of debt, can the government continue to issue at this low rate and how will the government pay for this? And, what if interest rates increase and the cost of debt grows?
As you can see below, Federal government spending has “exploded,” and this doesn’t include the most recent multi-trillion-dollar Biden plan!
Government Total Expenditures
Source: https://fred.stlouisfed.org/series/W068RCQ027SBEA
There is very little dispute that spending has provided some boost to the economy. What has been surprising, though, is the rapid increase in personal savings rates, from less than 10% to over 20%, suggesting the money is not being spent as fast as was intended. We are at historical money movement lows as people are not spending as they did in the past. But what if we did? Could the economy handle that pressure without triggering increased inflation? Given the price increases we have seen, maybe this is a fortunate outcome?
In regard to US debt levels, as of February 2021, the interest on the $27 trillion (pre-Biden plan) in federal government debt was $378 billion. That’s 1.4%, which is pretty low-cost financing. The government and we (the taxpayers that have to pay that debt) are benefitting from low-interest rates. However, the government debt continues to increase and is near record levels for Debt-to- GDP, levels we experienced after WW-II.
US Debt as Percentage of GDP
Source: Congressional Budget Office
The ability to service this increasing debt has not caused the market to be overly concerned (yet). The recent Biden tax proposals are one way to increase revenues. Economic growth that creates taxable income is another. Both of these levers will likely be pulled.
But, what if interest rates increase? What if they start to get back to “normal” at 3%/year or even higher? Since most of the debt is relatively short-term, the cost of servicing this debt and the new debt will inevitably go up and could begin a dangerous cycle.
All of this data and uncertainty is what concerns Mr. Buffett and others.
The Will Be
A recent headline in CNN Business reads: “Inflation is Coming, the Question is When.”The article goes on to provide a range of evidence (much of which was discussed above). The author leaves you wondering if the day of reckoning is coming soon. Yet, as a reminder, financial markets don’t show this at all!
Overall, we continue to recommend remaining diversified across asset classes and geographies. We do not know if or when inflation is coming, or how much it might be. “Betting” on one scenario over another may leave your portfolio poorly positioned. And, as we always say, it is important to have your portfolio designed around your particular situation with enough flexibility to build through different investment environments.
1 Market Briefing: Nominal & Real Yields & Inflationary Expectations by Yardeni Research, Inc.
