Inflation is Inevitable. Or is it?

May 14, 2020

When you hear the word “inflation”, it sounds like a tall tale your grandparents would tell you as a kid. “When I was your age, we had unicorns, dragons and inflation.” With the massive stimulus package recently passed by Congress due to the Coronavirus, the key question is, who will pay for all of this? Many experts and economists debate this very question, and if it will ultimately result in higher inflation.

What drives inflation?

Inflation is the rate at which prices increase over time. While there are many indicators, the Consumer Price Index (“CPI”) is the one you hear about the most in the news. If CPI goes higher, we have inflation.

It’s important to note that there are many contributors to inflation, not just money supply.

For example, with supply and demand, if too much demand chases too few goods, prices go up. But if the opposite happens, prices go down, resulting in deflation.

A classic example of this is the recent oil collapse. Prices went negative in April for the first time ever, due to evaporating demand and producers not cutting supply.

Source: YCharts, data last 5 years through 5/11/2020

In addition, if production costs increase but demand stays constant, it too can lead to inflation. This is what happened in the 70s.

There is more to it of course (cost-push and demand-pull references aside), but you get the idea. It’s not just about money supply (i.e. printing money).

That said, why would an increase in money supply be inflationary? It’s because more money in the economy increases the demand for goods and services. Supply stays constant in the short run, as companies can’t produce enough to meet newfound demand. This, in turn, can cause prices to rise and result in inflation.

But will it? Recall there were many predictions of hyperinflation in the 2008/2009 crisis, none of which materialized despite unprecedented stimulus at the time. In fact, the Fed struggled to reach it’s 2% target for over a decade, despite the longest economic recovery in history that was underway.

What does history tell us?

While it’s impossible to predict the future, we can use history as a guide. Let’s look back to see what happened in previous recessions. Although we aren’t technically in a recession yet by definition, in reality, we certainly are, so this can provide some insight.

Source: JP Morgan

The shaded areas above indicate recessionary periods. The light-blue line represents headline CPI (which includes the volatile food and energy sectors) while Core CPI, the dark brown line, excludes them.

You can see that inflation generally falls during recessions. But despite the upticks that immediately followed, the long-term trend has been downward since 1980.

Will it be industry-specific?

Some experts feel it’s more likely to see inflation in certain industries in the mid- to long-term, versus overall. Why is that? Because certain industries may be forced to adjust more than others to operate. For example, airlines have been exceptionally hard hit. The cost to create a process of social distancing can mean more cleaning, more empty seats, fewer concessions, etc.

Other industries hardest hit may also face higher safety costs, such as restaurants, theaters, entertainment venues and so forth, either due to increased regulation or just to instill enough confidence that it’s safe for customers to return.

This combined with having to potentially operate at reduced capacity for an indefinite period may result in higher prices for the consumer once demand returns.

However, industries that can operate as well or even more efficiently than before may see costs decrease as a result. For example, businesses that can ditch their brick and mortar locations.

What are the markets saying?

Spreads on Treasury inflation-protected securities (“TIPS”) provide a market-based measure of inflation expectations. Over the next five years, those spreads are currently at 0.75%. That hardly indicates runaway hyperinflation. Looking back at these same spreads in the 08/09 crisis, they were remarkably accurate in setting expectations vs. actual inflation.

Source: Federal Reserve Bank of St. Louis

What will ultimately happen? The truth is, no one really knows and only time will tell. But one thing still holds true – a sound investment strategy and financial plan will continue to serve investors well during these unprecedented times.