Will Next Year's Inflation Spark Ignite a Flame?

Will Next Year’s Inflation Spark Ignite a Flame?

12/17/20: Market Update by Jack Ablin, Chief Investment Officer at Cresset

Thanks to a handful of vaccines, life in the developed world is expected to return to normal starting in the second half of next year. That’s especially welcome news to all the travel and entertainment industries that have seen demand for their businesses evaporate this year. Private transportation prices, from airfare to ride share, fell more than 10 per cent year over year through May, with airfares off more than 20 per cent year over year through April. That suggests prices will rise 16-25 per cent over the next 12 months if fares simply revert to pre-pandemic levels.  

Inflation could run hotter than the Fed’s 2 per cent target next year, fueled by a surge in demand for services, like travel and entertainment, once millions of cooped-up Americans have been vaccinated and safety measures are relaxed. Faced with stay-at-home orders, Americans are saving a greater share of their income because of the reduced number of spending alternatives. The need to get out, combined with a stockpile of cash, could unleash outsized demand for travel and entertainment which, over the near term at least, could drive prices – particularly airfares, since airlines are operating at about 25 per cent capacity. Luxury tour operators are already reporting record advance bookings for high-end travel in late 2021 and 2022, according to Barron’s. The Galápagos Islands took the top spot for sales growth, followed by Antarctica, Tanzania and Madagascar.

Given price trends over the last 40 years, consumers, investors and even policymakers are taking disinflation for granted. Four drivers set in motion a long-term downward pressure on price growth. The first was aggressive monetary policy. In the early 1980s, Fed Chairman Volcker was willing to ratchet up short-term interest rates to 20 per cent. This resulted in a recession and bear market in the short run, but Volcker established the central bank’s credibility as an inflation fighter, independent of political and market pressures. The second driver was globalization. The outsourcing of relatively higher-priced manufacturing labor to cheaper, developing countries helped unleash both lower prices and corporate profitability. The third driver was technological innovation that enabled users to get more done with less effort. The internet, for example, introduced competition though pricing transparency and eliminating the middleman. The fourth driver, which arose as a consequence of outsourcing and innovation, was that income growth gravitated to the highest earning households, which tend to save a greater share of their income.

Globalization has eliminated 8.3 million American manufacturing jobs since 1978, according to the Bureau of Labor Statistics (BLS). Many of those good-paying positions were replaced by lower-skilled food service jobs. By the end of 2019, before the pandemic, the number of jobs in food service equaled the number of jobs in manufacturing. Prior to 2000, technological innovation expanded the labor market, as new technologies gave birth to new industries. Since then, however, productivity gains have substantially outpaced labor force growth, suggesting the latest innovations are eliminating jobs. The benefits of outsourcing, innovation and low interest rates have disproportionately benefitted high-income earners, who are often the most highly educated and possess specialized skills. The top 5 per cent of America’s highest-earning households saw their income rise at an annualized rate of 4.3 per cent over the last 10 years, while income for the bottom quintile rose at an annualized rate of 2.8 per cent.  This income trend drew away from consumption, since the marginal savings rate is much higher among the highest income brackets.

Some of the trends that helped established secular disinflation, however, are about to reverse.  Nationalism, fueled by resentment among blue collar workers victimized by outsourcing and innovation, is turning many developed market countries inward. The United States is no exception. “America First” policies will slow, if not reverse, globalization trends. The COVID-19 experience, which exposed our strategic vulnerability to our trading partners, will accelerate the “Made in America” trend. Reshoring is a concept on which both Republicans and Democrats agree. According to Joe Biden’s campaign website, “[Biden] will implement fundamental reforms that shift production of a range of critical products back to US soil, creating new jobs and protecting US supply chains against national security threats.” Bringing good-paying jobs back to blue collar America is a politically palatable solution to address the growing dissatisfaction this constituency has expressed. Strategic interest or not, domestic production will undoubtedly shift higher costs onto the consumer.

Large aging populations in developed economies could lead to workforce shortages, particularly if lawmakers resist modernizing immigration policies. Here at home, some of the impact is offset by older Americans staying in the workforce longer. In fact, the only age categories where labor participation has increased over the last 20 years are 55 years old and up. Innovation and robotics could fill gaps in manufacturing and some services, but the fact of an increasingly aged population will eventually exert upward pressure on wages.

Back in the 1970s, inflation was the biggest financial risk America faced. Lawmakers not only respected inflation, they feared it. President Nixon imposed wage and price controls to no avail. The spiraling CPI prompted President Ford to marshal the “Whip Inflation Now” movement – complete with buttons. Inflation and high energy prices were big contributors to cardigan-clad Jimmy Carter’s one-term presidency. Policymakers nowadays aren’t worried about inflation. In fact, many of them, including Federal Reserve governors, would welcome it. This year’s federal budget deficit is set to exceed $3.5 trillion, or about 17 per cent of GDP. Money creation is pushing similar extremes: money supply has mushroomed a whopping 25 per cent year over year, its largest annual expansion on record. Washington policymakers are banging the inflation beehive with a baseball bat, hoping inflation reemerges. Be careful what you wish for.

In the 1990s, a new breed of economists dismissed the monetary influence of inflation and developed a “New Keynesian” alternative framework of inflation drivers. Rather than focus on money creation, the New Keynesian model believes inflation is fueled by a combination of the public’s expectations of rising prices combined with a tight labor market. From that perspective, the inflation outlook is mixed. Recent experience does suggest the relationship between monetary policy and inflation is broken. Even Milton Friedman, the evangelist of monetary policy, admitted later in life that the short-term linkage between money supply and inflation had disconnected. Notwithstanding the pandemic, labor markets are tight.  Despite today’s economic challenges, job openings in many industries are on the rise. As of October, there were nearly 1.4 million job openings in education and more than 1.2 million openings in professional and business services, according to the BLS. It wasn’t long ago that the nation’s unemployment rate was 3.5 per cent, its lowest level since the 1960s. We expect improving trends to get back to those levels sometime in 2022.

Inflation expectations among households and the investment community are low, but rising. Consumer expectations of inflation, while historically higher than those of investors, have consistently overshot actual inflation for nearly 10 years. Investors, who have done a better job of predicting actual inflation, are beginning to raise their CPI forecasts, based on the yield differential between Treasury Inflation Protected Securities (TIPS) and fixed-rate Treasuries.

Investors should brace for an inflation flare-up sometime in H2/21 as lockdown-weary consumers, armed with an oversized cash cushion, emerge from their bubbles with a desire to spend. At the same time, supplies of both goods and services will be constrained as businesses rebuild capacity. The supply-demand mismatch, combined with higher than usual year-over-year price gains as the prices of travel and entertainment offerings are restored to pre-pandemic levels, will push inflation indicators above the Fed’s target. Whether or not next year’s price spike metastasizes into a self-sustaining inflation cycle will depend on inflation expectations and a credible perception that the Fed would be willing to tighten monetary policy to rein in inflation.

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