For the unprepared, rapid inflation can eat away at real earnings as prices can jump ahead of pay raises
While it is still early, the signs of emerging inflation are beginning to surface again in the U.S. economy. For many younger folks who have only lived in a world marked by deflationary forces of declining interest rates and cheaper technology, inflation is a foreign concept. It’s difficult to spot, and there may be uncertainty in how to prepare for higher prices.
Even before the Great Recession took down global demand along with stock and home prices, technology and globalization were eating away at inflation’s foundations. (Note: Inflation is defined as a period of rising prices, while deflation is defined as a period of falling prices.)
In practice, the Federal Reserve always shoots for a modest and steady rate of inflation for the U.S. economy. Right now the Fed’s target rate over the medium-term is around 2.0% per year on a measure of consumer inflation called core-PCE (i.e., Personal Consumption Expenditure Inflation Excluding Food and Energy). In August, this measure of inflation, the Fed’s favorite measure, moved up to 1.7% -- not far from the Fed’s intermediate target of 2.0%. This is the highest reading on this inflation measure since September 2014.
We’ve turned a corner on inflation
Consumer inflation had been on the decline since July of 2014 due to a 60% drop in oil prices, big declines in other commodity prices, and a strong U.S. dollar that has pushed down or held down the prices of many imported goods, such as apparel. But since July of 2015, core consumer inflation has been on a slow, steady rise and is now within spitting distance of the Fed’s inflation target.
A number of factors are responsible for the return of inflation. Perhaps the biggest underlying factor is the improvement in the U.S. labor market. The U.S. unemployment rate has been holding near full-employment levels since October of 2015. Job openings are the highest on record, and initial jobless claims, an indicator of layoffs, is at its lowest level since the 1970s. Average hourly earnings are starting to respond to the lack of labor supply. Average hourly earnings in information services and leisure and hospitality have increased about 4.0% from a year ago, and consumers are becoming more aware of their newfound buying power. In fact, The Conference Board Consumer Confidence Index hit an expansion high in September, as more consumers saw jobs as plentiful rather than hard to get.
Global crude oil prices bottomed in January and are up 39% since then; while a broader measure of global commodity prices are up 17% since January. These price increases on crude commodities will feed up through the supply chains and eventually surface at your local retailer. The downward pressure from import prices is expected to fade as the U.S. dollar has weakened since the beginning of the year.
The latest consumer price index release also showed a marked increase in the cost of medical care and services. Medical care prices were up 4.9% and service prices were up 3.0% from a year ago, well above overall consumer price increases. Consumers’ inflation expectations have also risen over the last two months to their highest level in nearly a year, according to the Conference Board.
For the most part this rebound in prices and earnings is good news, given previous fears of prolonged deflation and lackluster global growth. But rapid inflation can be bad for the unprepared. It eats away at real earnings as prices can jump ahead of pay raises.
People on fixed pensions see their real spending power sapped, as costs for medical care and housing go up with all the other prices in the economy. It can cause businesses to misinterpret price signals, either leading to mis-investment or hurting profitability if they are too slow to respond to rising cost structures. Bond investors and banks will demand higher interest rates from customers, and stock prices could be hit as higher inflation requires a higher discount rate on future earnings.
We’ve lived through it before
Inflation, if it becomes persistent, gets embedded into consumer and business expectations, employment contracts, vendor contracts, etc. Once higher inflation expectations become ingrained they are very difficult to extinguish and can lead to sustained high-inflation or even hyper-inflation in the extreme.
It could also cause the Federal Reserve to respond aggressively to curtail inflation expectations from getting out of hand, leading to a rapid succession of interest rate hikes that could spark a downturn or recession in the economy. This actually occurred in the late 1970s in the United States, when high price inflation and double-digit interest rates became entrenched. It took the head of the Federal Reserve at the time, Paul Volker, to stomp on the money supply and push interest rates up to a point where the economy fell into a deep recession. The Fed at the time was successful in beating down inflation expectations, but at the cost of a nasty dislocation in the economy.
While we are still far from a 1970s situation today, now doesn’t seem like too bad of a time to start preparing for a shift in the consumer inflation winds.
