Data Shows Inflation Will Be Transitory, or Not

August 19, 2021

Source: Bloomberg Source: Bloomberg

One of the benefits associated with working from home is the greatly reduced cost of commuting. Suburban dwellers like me are saving money on gas, road tolls, car maintenance, morning coffee and so on. My car insurance carrier even lowered my insurance premium.

However, one thing I did not consider is that my car could be worth more than it was a few months ago. According to the Consumer Price Index (CPI) published by the U.S. Bureau of Labor Statistics, used vehicle prices increased by approximately 30% from January to July.

Both the supply of and demand for vehicles have contributed to this atypical price action. On the demand side, as the U.S. economy has been reopening and supported by fiscal stimulus, there is pent-up demand for items people did not have access to during the lockdowns. As a result, the demand for vehicles is exceeding normal levels.

On the supply side, car manufacturers are struggling with supply chain disruptions caused by the pandemic. This is mostly due to a shortage of semiconductor chips, which are essential for modern-day cars fully equipped with electronic systems. Car manufacturers are partly responsible for the chip shortage, as they underestimated the speed of the economic recovery. After ordering fewer chips than usual from chip makers in 2020, they tried to keep up with consumer demand this year but found themselves stuck in a long chip-ordering queue.

Ford’s revenue for the second quarter is about $10 billion lower than the previous three quarters. Volkswagen is drawing up plans to design its own chips in an effort to gain more control over these vital components in the future. The insufficient new vehicle supply has also spilled over into the used vehicle market.

In July, U.S. inflation measured by CPI increased year-over-year by 5.4%, a reading that had not been seen since the great financial crisis of 2007-08. The Federal Reserve (Fed) has a mandate to maintain price stability, which can be roughly translated to a CPI reading of around 2.3%. Naturally, a debate has been trending about how transient high inflation is likely to be, since this will have huge implications for near-term monetary policy.

This week’s chart breaks down 2021’s monthly CPI changes into components. As we can see, used vehicle prices contributed materially from April to June before cooling off in July. This lends credence to the view that recent high inflation is an effect of the economic reopening, and hence will be transitory. Fiscal stimulus will eventually wane. The fact that longer-term inflation expectations remain well-anchored helps bolster this argument as well.

But there is evidence to suggest that high inflation could be more drawn out. Home prices were 18% higher at the end of May compared to a year earlier, according to the Federal Housing Finance Agency Purchase Only House Price Index. Even though home prices are not directly included in the CPI calculation, they will gradually influence rent prices. Also, there is no end in sight for supply chain disruptions, which have been the primary drivers of the current high inflation, as long as COVID-19 is still causing lockdowns all over the globe.

Key Takeaway

Future monetary policy will be dictated by whether the pandemic has heralded sustainable high inflation, or a return to pre-pandemic moderate inflation is on the horizon. This path, in turn, will greatly impact investment performance. Uncertainty is high, which warrants some level of inflation hedge. Medium- to long-term market inflation and interest rates have little inflation risk premium priced in. Regarding equities, a high-inflation environment would mean that financial, energy, material and REITs are likely to outperform.

Tags: Inflation | Monetary policy | COVID-19 pandemic | Interest rates | CPI

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