A Higher Inflation Regime?
Inflation has been a heavily discussed topic, and for good reason. Inflation hasn’t been this high
since the early 1990s (see graphic). There have also been many media stories, blogs, and expert
articles predicting that this high inflation is here to stay, especially after the Federal Reserve (the
Fed) took the “transitory” label off its inflation expectations.
First, let me talk a little about the type of inflation measure to pay attention to and why the Fed
chooses to focus on core personal consumption expenditures (PCE) rather than the headline
consumer price index (CPI), which is the measure most commonly referenced in the news. First,
the difference between core and headline is the exclusion, or not, of food and energy,
respectively. Second, CPI measures the price changes of a fixed basket of goods, while PCE
measures what you and I are actually buying. So, for example, if a bottle of ketchup from the
brand in the CPI basket goes up in price by 40%, I will be buying a different brand that didn’t go
up in price like that. PCE picks up that change in my behavior and tracks how much more I am
spending, but CPI does not.
What would it take for core PCE to stay significantly higher than pre-COVID? Quite a number
of things would have to work together to keep inflation well above the Fed’s 2.0% target for an
extended period of time. Some of the most influential would be:
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long-term inflation expectations would need to average well above 2.5%,
the global output gap would need to be chronically positive,
real wage (pay after inflation and taxes) growth would need to stay out of negative
territory more often than not to support demand levels,
the U.S. dollar would need to weaken over a long time period,
and real GDP growth would need to remain positive.
APCM’s expectations are that all these inflation drivers will not “conspire” to push inflation
above the Fed’s target over the long term. Since 1958, the period from 1970 to 1980 was the only
period during which inflation was high for a 10-year period – a decade that included the removal
of the gold standard, the OPEC oil embargo, and the Iranian Revolution.
Included is a graphic from the Visual Capitalist that can help us understand the history. It shows
CPI inflation (higher than PCE, but still provides a gauge of whether inflation is above average),
real wage growth, and negative real GDP growth periods (recessions). Only once, in 1970, an
inflation spike did not result in negative real wage growth. Once real wage growth turns
negative, the demand causing the inflation (input cost inflation and/or finished goods
inflation) must fall in the future. The only places consumers can get the money to continue to
demand as much as they have is from their earnings or their savings. And savings eventually run
out.
There are a great deal of economic data points, theories, and interactions that will determine
whether the Fed is successful in meeting its 2.0% average inflation target. And it is completely
plausible that the Fed will tolerate inflation above its target for a time past 2024 and allow the
next recession to push the average inflation rate back to its target over the long term (i.e., take
opportunistic advantage of the disinflation that occurs during recessions). This was by no means
an exhaustive treatment of why APCM does not think we are on the cusp of a higher inflation
regime. But for the sake of brevity, understandability, and since I know that not everybody likes
to think about this in their down time, I thought focusing on one piece that is pivotal would
provide some understanding of the basis for our expectations.
With APCM’s expectation that the Fed will successfully manage inflation over the long run to its
target, our long-term inflation expectations are just slightly higher than previously at 2.25%. The
increase is because we know inflation this year, and likely next, will be higher than target. So,
two to three periods higher than 2.0%, and the other seven to eight moving down to average
2.0%, gets us an average over ten years of 2.25%.
As always, your team here at APCM is available and happy to address any questions or provide
further information on this or any investment topic.