This past week was filled with inflation numbers that have come out. As expected, inflation has heated up. Between the supply shortages and liquidity balances that consumers have, no one can be surprised that prices are on the rise. I have written quite a bit about this over the past two months, setting some expectations. The key numbers right now are not the year over year inflation level, but the month over month increases. Remember that for most of 2020 the world was essentially shut down in regard to purchasing anything beyond core necessities. Many commodities and non-essential consumer goods were sitting on shelves gathering dust. We experienced a bout of deflation for a period last year. Remember when oil went into a negative price in May? We need to keep an eye on the monthly inflation numbers as they will add up, showing a compounding factor for inflation this year. If you consider just the CPI, adding the numbers month over month since January, inflation is running over 2% for the first four months of the year. If you anticipate a linear progression the low end of inflation for 2021 should be 6.3%. If the most recent trends continue, we could be upwards of 10%.
Inflation is currently made up of two key factors. The amount of cash in the hands of consumers is immense. You have to go back to 1945, coming off the impact of World War II to really model anything like what is going on now. Consumers had four years of savings piled up. Pen up demand for everything from homes to cars to baby clothes was burgeoning. The Dow Jones rose from 152 to 191 during 1945, an increase of 25.6%. While inflation was tame in 1945, it ballooned to 8.33% in 1946. Spending will drive up prices, however, the well is not unlimited. The coffers of savings and pent up demand will pass. Demand is expected to peak for many durable goods this Fall.
The second factor is the supply chain. There are noted shortages that all of us have experienced. As manufacturing firms get back to full production, both in the US and the world, supply will build to reach the level of demand. China is already nearly fully reopened and India should be past the worst of their current surge given two or three months. The US production is expected to be nearly normalized by September. We are already seeing supplies of finished lumber increasing. Once the chip shortage is over, auto production will catch up quickly.
The same scenario occurred in 1945 to 1948. Lots of cash, lots of demand, a massive re-tooling from military to consumer production leaving supply short for a season. Once the cash ran out, the demand dried up and supply caught up, the economy fell into a recession in late 1948.
We are still early in the session, however, trends are pointing to a tough 2023. The level of inflation we are currently seeing is transitory in my opinion. Higher inflation rates than we have seen since the 1970’s and 80’s will likely hold through mid 2022, then level off. Demand will slack off as interest rates rise and the consumers exhausts both cash and desire. As supply builds up, prices will stabilize.
The major concern on the horizon is the reaction of the Federal Reserve. Over the next month the US treasury will have to finance the trillions in debt that is currently being spent. Any borrower desires the lowest rate possible to pay on the debt they take out. The US Debt is sold on the open market to buyers. Buyers or financers of the debt, want the highest price for the use of their money. If the price is not high enough, they wait to purchase until the rate increases. The Fed, using quantitative easing policies is holding the interest rate down by clearing the market through their purchases. As long as the US Dollar is the Reserve Currency of the world, that works. However, being the least dirty shirt on the block only lasts so long. What if the world tires of the financial shenanigans of the US and seeks out a new reserve currency? Personally, I would rather not go there.
The Fed and the US are between a rock and a hard place right now. The Treasury needs to borrow big time, at the lowest possible rate. The buyers of our debt, Japan, China, Russia, Saudi Arabia, personal investors, retirement funds, etc. are watching carefully. If the Fed depresses rates by purchasing the T-Bills, our rates stay artificially low, producing an economy that overheats quickly, moving that transitory inflation into possible long term high inflation. On the other hand, if the Fed abates and lets long term rates rise at a measured level, keeping our debt buyers in the game, we could see a softer landing for the economy as well as maintaining that inflation concern in the transitory phase.
Keep an eye on the T-Bill rates and how they move from now to October, it will tell you a lot about the future.
Have a great week.