“Inflation is when you pay 15 dollars for the 10-dollar haircut you used to get for five dollars when you had hair.”
— Sam Ewing
It’s hard to look at any type of financial publication these days without seeing a headline about inflation.
The annual inflation rate in the U.S. spiked up to 4.2% in April of 2021 from 2.6% in March and was above the market forecasts of 3.6%.1 It is the highest reading since September of 2008 and comes amid a surge in demand as the economy reopens, commodity prices rebound and supply is constrained coming out of the pandemic. The May 2021 inflation number due later this week is forecast to be even higher at 4.7%.2
Where exactly are consumers seeing prices rise?
With all the hype around the headline inflation numbers, it’s helpful to take a step back and understand what prices are increasing and why.
We have to consider that any annual numbers we are looking at are being calculated off a very low baseline from April/May of last year when lockdowns were still largely in place and business activity in many segments of the economy — think tourism, restaurants and retail — had ground to a halt. This is known as the base effect.
In April of last year, the inflation reading was just 0.3%3 because of COVID-19-related shutdowns. The most recent inflation report as of April 2021 showed inflation up 4.2%, with the sharpest increases coming from gasoline, fuel oil, and used cars and trucks. Used vehicle prices were impacted by a global semi-conductor shortage that has constrained new vehicle supply. Inflation also increased for shelter, new vehicles and apparel but slowed for medical care services and food.
How does the current inflation rate compare to prior periods?
A picture is worth a thousand words. If we look at a chart of annual inflation over the past three decades, we see that inflation has been generally trending down over this period. The last time inflation spiked higher than the current level was in July of 2008 when oil prices increased to $147 per barrel.4 As of June 7, 2021, oil prices are less than half that number at about $70 per barrel5 (remember those base effects).
Another point worth noting in the chart is how periods of quantitative easing (in orange) appear to coincide with rising inflation, and periods of quantitative tightening (in green) appear to coincide with declining inflation. This would indicate that the Fed in the recent past has been able to impact the price level through its actions. Or, said another way, the tools the Fed has in its toolbox to combat inflation appear to have been effective.
Will inflation effects be transitory or sustained?
The Fed maintains that the high current inflation level is likely transitory, and that it is comfortable allowing the economy to run hot for a time to reach full employment. The May jobs report showed unemployment falling to 5.8%, but this level is still well above pre-pandemic levels.6
The question some are asking is whether the Fed is underestimating the impact that the level of monetary and fiscal stimulus being pumped into the economy could have. One of the concerns is that the expectation of inflation can be a powerful enough force to cause inflation — as commodity prices increase, companies raise their prices, labor expects higher wages and the cycle continues, resulting in higher price levels across the board.
The tea leaves are difficult to read on this one, and we don’t attempt to predict the future. Instead, our focus at Wipfli Financial Advisors is to build portfolios that can withstand uncertainty.
What types of investments hold up well during an inflationary environment?
Staying invested is your first line of defense; leaving money in cash on the sidelines — beyond what you may need as “cash reserve” — means that you lose purchasing power over time because that money isn’t earning anything.
Second, having a healthy allocation to stocks is important because stocks historically have provided strong real returns that exceed inflation. Why is that the case? Even as prices for commodities and other inputs rise, companies continue to add value in the goods and services that they sell.
Additionally, while some companies’ profitability may be impacted by rising input prices, others may be able to pass along price increases to consumers and continue to generate strong returns for investors.
Some investors look to add direct exposure to commodities as a potential hedge against inflation. We are not strong proponents of this approach because commodities tend to be very volatile, whereas inflation is a much more stable phenomenon. Furthermore, investors in a globally diversified portfolio already have indirect exposure to commodities through their holdings of companies that mine and produce commodities.
Time will tell whether the current uptick in inflation is a transitory phenomenon or the beginning of a sustained rise in price levels, but your investment portfolio can be constructed to help navigate what lies ahead. If you have any questions or would like to discuss how to create a portfolio that is well-positioned to withstand current and future uncertainty, contact a Wipfli Financial advisor.