The unpleasant surprise of inflation

It may not be “transitory”

The economic and monetary authorities are united in their view that the recent rise in inflation is purely “transitory,” a synonym for temporary, and that it is due to a specific set of circumstances that won’t be repeated. Whether it’s Fed Chairman Jerome Powell, the European Central Bank’s Christine Lagarde, or the Bank of England’s Andrew Bailey, they all declare that the present rapid increases in the Consumer Price Index (CPI) or Retail Price Index (RPI) are due to the effects of the pandemic, or rather the lockdown measures that were taken to combat it this time last year.

With U.S. CPI rising an annual 4.2% in April, 5% in May, and 5.4% in June, the fastest pace since August 2008 and higher than Wall Street expectations, it’s understandable that some observers are becoming concerned about how rapidly prices are rising. It’s not merely in the U.S. either. The U.K.’s RPI index doubled from 1.6% in March 2021 to 3.3% in April this year. In Europe, mired in deflation for much of the last decade, the rate of inflation has risen from under 1% in February to 1.6% in April, while Canada’s CPI rose from 2.2% in March to 3.4% in April, the highest since 2011.

Where the price increases are

Even excluding food and energy, the so-called core inflation rate in the U.S. rose 3.8%, the highest since 1992. Gasoline prices are up 56.1% over the last 12 months and the energy complex as a whole is up 28.5%, as oil prices have more than doubled to over $70 a barrel from their Covid-19 induced slump in April 2020. So it’s unsurprising that some commentators choose to ignore such volatile elements of the index. However, the higher cost of fuel feeds through into any number of other sectors, such as transportation, plastics, and utility costs.

Interestingly, used car and truck prices were one of the elements driving the index higher, up 7.3% in May and 29.7% over the last 12 months. This is due to the worldwide shortage of microchips causing automakers to substantially reduce production of new cars, whose price was up 3.3% over the last 12 months, itself the highest increase in a decade. As a result, buyers have turned to used car dealers, and the average age of an automobile on the U.S. highway is now 12 years, the highest ever.

What’s behind transient price hikes?

Undoubtedly there is some truth in the authorities’ claims that the present spike in consumer prices is due to the effects of the pandemic. Essentially the developed Western economies of North America, Western Europe, and Japan chose to shut down their economies for the second quarter of 2020 to stop the spread of Covid-19, at a time when there was no vaccine and no clear understanding of how infectious and deadly the virus was. Therefore the year-on-year comparisons are from an extremely low base, witness energy’s 28% rise.

Also with many consumers unable to spend due to restaurants, shops, hospitality, and leisure outlets being either completely closed or only open on a very restricted basis, there is a great deal of pent-up demand for goods and services, which even the success of e-commerce and home delivery has been unable to satisfy. At the same time, many businesses have gone under or, if they have survived, have sharply reduced their output anticipating much reduced demand.

This is one of the reasons for the extreme shortage of microchips. Chipmakers’ customers, such as automakers and computer companies, reduced orders sharply in anticipation a bad recession. But they were blindsided by the sharp recovery in demand due to government support programs such as the furlough scheme in the U.K., which paid 70% of laid off workers’ salaries, or the three waves of cheques totalling $4,200 that the U.S. government sent to all U.S. citizens in the last year.

Now that the U.S., Western Europe, and most of Asia have emerged from the lockdown, people are ready to spend, and have money to do so. But the supply of goods to satisfy their demands is reduced due to supply constraints. Specific logistic issues, such as the temporary blockage of the Suez Canal, or the much longer-lasting hold bottlenecks at the California ports of Los Angeles and Long Beach where Covid regulations have delayed unloading ships, have exacerbated the situation. A fire at a major Japanese chip factory and a drought in Taiwan affecting the world’s largest chip maker, Taiwan Semiconductor Manufacturing (TSMC), have contributed to the shortage.

The ballooning money supply

The underlying reason for the increase in inflation, however, may be found in the enormous expansion of the money supply by central banks and the authorities in the last 15 months to offset the effects of the lockdowns. With government deficits having exploded to the highest percentage of GDP since World War Two, governments, much as they might deny it, have a a vested interest in creating some inflation, as inflation erodes the real value of the debt that has been issued.

The most appropriate comparison is probably the U.S. in the 1960s, when, under Democratic President Lyndon Johnson, the government attempted to fund both the Great Society social programs like social security, Medicaid, and Medicare and the Vietnam War without raising taxes to pay for either. It was a policy that was nicknamed “guns and butter” and while inflation stayed relatively low for a few years in the mid-1960s, once investors realized that government borrowing and spending meant higher prices, inflation started to accelerate and bond yields shot up.

The unpleasant history of monetizing debt

It culminated in President Nixon’s taking the U.S. off the gold exchange standard in 1971, where, under the Bretton Woods agreement, the U.S. would exchange U.S. dollars for an ounce of gold at $35 per oz. Freed from the restraints of the gold standard, inflation surged, quadrupling the price of crude oil to $12 a barrel due to the Yom Kippur Arab-Israeli War in 1973 and doing so again after the overthrow of the Iranian Shah by Ayatollah Khomeini in 1979. Inflation reached 12% in the U.S., and 25% in the U.K. in the 1970s. Bonds were nicknamed “certificates of confiscation” as their value was eroded by rapid inflation. And political discontent with existing governments and their failure to deal with the problem led to the rise of Ronald Reagan and Margaret Thatcher.

While not suggesting inflation will reach the double-digit levels of the 1970s and early 1980s, investors should be aware that central bankers have no more idea than the average investor as to how high inflation will rise. Given their unwillingness to raise interest rates, they also have no means of controlling it should inflation prove not to be transitory.

No one who has entered the markets since the early 1980s has experienced a full-blown inflation and the effect it can have in investment psychology. They may about to be unpleasantly surprised.

Gavin Graham is a veteran financial analyst and money manager and a specialist in international investing, with over 35 years’ experience in global investment management. He is the host of the Indepth Investing Podcast.

Notes and Disclaimer

The commentaries contained herein are provided as a general source of information based on information available as of June 10, 2021, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.

The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.