A Q&A on Inflation

The Fed’s preferred inflation gauge—the Personal Consumption Expenditures (PCE) Price Index—hit the wires Friday morning, showing inflation ticked up from 1.4% y/y to 1.6% February.^[i] That is below the Fed’s 2% target. But if we have learned anything in our many years of covering economic developments, it is that this won’t do a thing to quell inflation chatter. Many still think rapid inflation is inevitable as more businesses reopen, especially with fiscal stimulus talk picking up again. This week, we have seen a fair few pieces arguing we are seeing the initial signs of this, which we think makes it worth a look at what is—and isn’t—inflation. Mind you, we don’t think rising inflation is inherently a risk for stocks, which have actually done quite well during such spells in the past. Trouble generally stems from the Fed being too late to rein in prices and then over correcting, an event we think defies prediction. Still, having a better understanding of the supposedly inflationary news today can help you keep a level head when making portfolio decisions, so off we go.

First off, what the heck is inflation, really?

Glad you asked. Inflation is a general rise in prices across the entire economy. Inflation measures use broad baskets of goods and services in hopes of capturing broad trends accurately. These include the aforementioned PCE index as well as the Consumer Price Index (CPI) and private-sector gauges like MIT’s Billion Prices Project. At any time, some items in these inflation baskets will rise while others will fall, but those outliers cancel each other out and let the broader trend emerge.

What causes inflation?

There are various schools of thought, and this is really a topic for a book. We generally subscribe to Nobel prizewinning economist Milton Friedman’s pithy view: Inflation is a monetary phenomenon—too much money chasing too few goods and services. Historically, the Fed has focused on the money part of this, adjusting interest rates and bank reserve requirements in hopes of keeping money supply and velocity (the rate at which money changes hands) growing fast enough to fuel economic expansion, but not too fast, lest the economy overheat. That is jargon for too much money sloshing around with no productive use and thus pushing prices higher.

Do high oil prices fuel inflation?^[ii]

Energy is a component of CPI, PCE and most inflation indexes, so yes, it contributes to inflation. But oil prices, like food prices, are frequently subject to market forces that have less to do with monetary drivers, so there are “core” inflation measures that exclude them. The theory there is to give a clearer look at trends that big swings in commodities might be hiding. Note, however, that the Fed does NOT target core PCE. It targets headline PCE.

Some argue energy prices can bleed into other consumer goods and services by driving up businesses’ costs, forcing them to pass these costs onto consumers. This is possible on a case-by-case basis, but corporations that consume a lot of oil generally hedge using futures contracts so that they can avoid this outcome. (This is similar to companies that import parts and labor and hedge for currency swings to keep costs stable.) Companies also don’t pass every cost on to consumers—sometimes they elect to keep prices low to attract demand. When plunging oil prices pulled headline PCE near zero in 2015, core PCE didn’t budge much.^[iii] Same goes for when rising energy prices temporarily lifted headline PCE in 2011 and the mid-2000s.^[iv] Core PCE rose less. Now, the two moved much more in tandem in the 1970s, which is the period on everyone’s mind right now. But there were a lot of other things going on then, like the expiration of price controls and some ill-advised Fed policy, and the US economy was much less energy-efficient then. 

I read a lot about semiconductor shortages driving up prices—not just for chips, but in the consumer goods made with them, like cars. Is that inflation? It sounds like an example of “too few goods.”

This gets into some interesting nuances, because yes, supply shortages contribute to higher prices. If a semiconductor shortage leads to shortages of cars, consumer electronics and the multitude of “smart” products using chips, that could drive those prices higher. But we are hesitant to call this inflation. We doubt it is something the Fed could address with interest rate hikes, for example. Plus, as ubiquitous as these goods are in everyday life, they aren’t an outsized chunk of the inflation basket. As mentioned earlier, the breadth of that basket helps even out niche, supply-driven developments like this.

Supply disruptions’ impact on prices is usually temporary. Today’s semiconductor supply shortage stems partly from production taking a hit during the pandemic. Rising demand has also played a role, but this imbalance probably isn’t permanent. Higher prices are a signal. They tell producers it is time to invest in new production. Semiconductor companies have received the message, with a major one announcing plans to build new foundries this week. Those construction projects take a while, so this isn’t an instant fix, but overall we see this as market forces working the way they are supposed to.

What about shipping costs? And that big tanker that got stuck in the Suez Canal? That can’t be good for prices.

We think this is another temporary factor, and the market seems to agree. They have seen through numerous shipping disruptions in recent years, from work stoppages at West Coast ports in the US to Brexit and the pandemic. All have caused backlogs of container ships (or, in Brexit’s case, trucks), much as we are seeing around the Suez Canal right now. But companies and the shipping industry adapted, and as the stranded ships eventually docked, longshoremen unloaded them at rapid speed and everything got where it needed to go. When shipping costs rise, companies do what they need to adapt. Everyone’s favorite shipping cost index, the Baltic Dry, has hit much higher levels than where it presently sits, without whacking global trade or causing a recession. When world trade did fall a few years ago, the global economy still grew and stocks’ bull market continued. And—you guessed it—inflation didn’t surge.