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Should You Be Worried About Inflation? Part 1

After three decades of a slow, albeit bumpy descent, inflation appeared to turn on a dime in April 2021, posting its highest year-over-year increase since 2009. The media has fixated on this surge, and economists are sounding the alarm over government policies that seem certain to unleash it further. The widespread consensus is that inflation looms large on the horizon if it hasn’t already arrived.  

Or not, according to many economists who insist that we are still in a low-inflation economy and that these spikes in inflation are transitory or outliers. Who is right, and should we be worried about the return to an inflationary environment? 

How Do We Measure Inflation?

Our high school textbooks teach us that inflation results from too many dollars chasing too few goods. In other words, in a growing economy, increasing consumer spending pushes demand up to where it exceeds supply which drives up prices. When the money supply increases (as it has with several rounds of economic COVID relief efforts) and consumers have more in hand to spend, the demand for goods grows and prices respond in kind.

As Americans emerge from year-long social distancing and stay-at-home orders, demand for just about everything from lipstick to Pelotons is surging. This has also put a significant amount of pressure on manufacturers that scaled back production last year and have had trouble catching up. So add a weakened and fragile supply chain to this high demand and demand grows even higher.

The signs would appear to be irrefutable. Spiking commodity prices surely must be the result of inflationary pressures predicted following the massive injection of money into the economy to stave off the pandemic-induced economic downturn. 

Historically, it has been almost a direct cause and effect scenario in which stimulative fiscal and monetary policies increase the inflation rate, so why would it be different this time?

This Time is Different

Before the pandemic, the Fed was struggling to lift inflation to its target level of 2%. In February 2020, it indicated it had no plans to raise short-term rates for the rest of the year. Then the pandemic hit. As a result of the pandemic-induced recession, the inflation rate dropped precipitously, turning negative in April and May of 2020.

Even as the economy started to roar back in late 2020 and early 2021, the inflation rate hovered in and around the Fed’s 2% target, with no signs of a possible surge. But, as the economy surged, so did the demand for goods and services. Yet, supplies have been slow to come back, thus creating price inflation across many segments of the economy. One can make the case then that, when production and supplies catch up with demand, inflation should return to its recent trend.

The Base Effect

The other phenomenon at work here is what is known as the “base effect.” What the Fed and many economists knew that most people didn’t is that the inflation rate would almost certainly spike in April and May due to the base effect. It works like this: The rate of inflation, or Consumer Price Index (CPI), is tracked on a year-over-year basis. For each month, the CPI is compared to the same month of the prior year. But this comparison may distort our view since 2020 was such an economic anomaly.

In April 2021, the year-over-year change was compared against a -0.4% inflation rate. Regardless of how small the increase for the month, the CPI was bound to show a significant jump. Although the month-to-month increase in CPI from March to April was just 0.8%[i], the seasonally adjusted year-over-year rate was 4.2%. Consumer prices jumped again from April to May by 0.6%, up 5% from this time last year—the fastest annual increase since 2008.

 

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Perhaps overlooking the base effect and measuring this year’s inflation against that of 2019 is more accurate. During the decade before the Covid-19 crisis, the consumer-price index rose 3.5% on average every two years. That was within a range between 5.8% in 2012 and 0.8% in 2016.

As of April of this year, the index was up 4.5% from 2019. So even though CPI numbers appear to be catapulting, they may be simply getting back on track. Inflation may be trending a bit higher, but not exceptionally so. As 2021 continues on and we compare back with the later months of 2020, it will be interesting to see if this gap narrows.

We are Here to Guide You

There is no doubt that inflation can be scary. Not only can it reduce the rate of return on investments but can also put your purchasing power at risk. When inflation is low, it is easy to overlook its impact. And when inflation is high, you may be tempted to make changes to your financial portfolio.

However, it is best not to make any major adjustments based on inflation alone. You should always consider this in the context of your overall financial picture including your personal circumstances and goals, investment time horizon, and risk tolerance. All of these important factors will dictate how it is best to proceed should we indeed fall subject to a higher inflationary period.

Of course, no one can truly predict where inflation will go. As the saying goes, “Past performance is not indicative of future results.” We continue to monitor the situation and will keep you updated should we recommend changes to your plan. In the meantime, we urge you not to grow too worried about what you may be hearing in the news. Your long-term financial plan is created with just these types of potential economic changes in mind.

[i] https://www.bls.gov/news.release/pdf/cpi.pdf 26 May 2021

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