Broker Check

Expect Inflation to be Contained

April 01, 2021
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It’s tempting to predict runaway 1970s inflation as an April Fools’ Day joke. But at the risk of upsetting our friends in the compliance department, we’ll shoot straight here. With that important disclaimer out of the way, here we provide 10 reasons why we aren’t worried about inflation long term:

1) Technological development. As we learned in our economics 101 textbooks, prices for goods and services tend to be tied to their marginal costs. As technological development continues at a rapid pace, costs to produce and distribute goods and services should continue to fall, putting downward pressure on prices.

2) Globalization. One of the reasons inflation has been well contained in recent decades is access to cheaper labor and manufacturing capacity in developing nations. Although political pressure to diversify away from China is intensifying, plenty of alternatives still exist—Vietnam, India, and Mexico, just to name a few.

3) Price transparency. Sometimes called the “Amazon effect,” consumers and businesses have never had an easier time comparison-shopping. The price transparency e-commerce provides has made it much more difficult for price increases to stick.

4) Labor substitution. Labor is the biggest piece of the inflation puzzle because it is such a large part of companies’ costs. As a result, when companies have the ability to replace labor with cheaper machines, employees have less leverage for more pay. Labor unions also wield less power today than they did decades ago, which hurts collective bargaining power.

5) Anchored inflation expectations. The trend is your friend as they say. Because prices have risen at such a modest pace over the past two decades, people have come to expect modest price increases and pushed back against anything more. Call it a self-fulfilling prophecy.

6) Fed credibility. Federal Reserve (Fed) Chair Paul Volcker famously broke the back of inflation in the early 1980s. Since then, the Fed has effectively won this battle—even if they lost some credibility by overshooting with their inflation forecasts during the last cycle. There are doubters, but we believe the Fed will be able to keep inflation under control.

7) It’s a show me story. Even the Fed was surprised at how little inflation the US economy generated during the last economic expansion (2009-2020). The Fed’s preferred inflation measure—the core personal consumption expenditures (PCE) index, excluding food and energy—rose at an average pace of just 1.6% during the last expansion (2009-2020) and 1.8% during the 2000s. Japan’s central bank has been trying to create inflation for several decades and failed. We’ll believe it when we see it.

8) Low interest rates. It’s tough for equity investors to admit this, but the bond market has historically been a pretty good predictor of long-term economic trends. Historically, until the last decade or so, economic growth plus inflation had followed a similar path as long-term interest rates. We believe still-low long-term interest rates reflect the market’s expectation that inflation will remain contained over the long term.

9) Demographics. The aging of the baby boomers has put downward pressure on economic growth and inflation. The rise of the millennials may begin to reverse that trend in coming years but that is still a long way off in our view. High debt levels may crowd out demand and investment, reducing inflationary pressures.

10) Link between money supply growth and inflation appears to be broken. Money supply, as measured by M2, has surged by an unprecedented 25% during the pandemic, leaving many to wonder why that extra money sloshing around from the Fed’s “money printing” hasn’t shown up in the inflation data. If that cash sits in consumer and business bank accounts, it doesn’t do much for growth or inflation. Until the funds are put to work and increase the velocity of money (a measure of the rate at which money is exchanged in the economy), inflation will remain subdued. We’ll call this another show me story.

Bottom line, brace yourself for much higher inflation in the coming months. But if we are right, those price increases will be temporary as weak data from a year ago rolls off and the structural forces that have been putting downward pressure on inflation for decades will come to the fore again. We suggest bond investors limit interest rate sensitivity given the expected increase in interest rates, and we continue to recommend an underweight allocation to fixed income relative to investors’ targets where appropriate. But we would not let the anticipated ramp up in inflation scare investors out of bonds, which remain a prudent diversifier of risk.

 



IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

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All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

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