The Great Inflation Debate

After being missing in action for years, inflation is back.

The Consumer Price Index (CPI) rose 5.0% in May from last year, the biggest annual jump since August 2008. Core CPI, which excludes food and energy because they can be so volatile, was up 3.8% from a year ago, its largest gain since June 1992.

The debate now shifts from whether we will see inflation return—it clearly has—to whether these lofty levels will be temporary or longer term and what the Federal Reserve will do it about it.

To be sure, a significant amount of recent inflation is from a booming U.S. economy. With much of the country vaccinated and looser business restrictions, consumers are spending again, fueled in part by substantial relief from the Fed and Congress.

But details in the data suggest that some of the inflation drivers are indeed temporary. For one, current year-over-year measures are heavily skewed by “base effects.” Numbers from a year ago represent readings from the depression-like environment caused by social-distancing efforts to mitigate COVID-19’s spread. So current numbers are being compared against a totally abnormal environment. Compared to the same period two years ago, May’s CPI was up only 2.5%.

Bottlenecks in the global supply chain are driving inflation. A shortage of semiconductors has limited production of new vehicles, which in turn pushed up prices on used cars and trucks by 29.7% in May from the year earlier. In time, these logjams should be resolved.

Policymakers around the world are taking notice. In China, where factory gate prices rose 9.0% in May from a year earlier, the state is selling industrial metals from its stockpiles to help tamp down increases in commodities costs there. And it signaled more price controls could follow. Meanwhile, the central banks of Brazil, Russia, and Turkey have raised their interest rates to help suppress inflation.

All eyes are now on the Fed, which falls into the “inflation is transitory” camp. As of this writing, the Fed has maintained its zero-interest-rate policy and massive bond-buying program. But much depends on the Fed getting this calculation right.

If the Fed continues to believe inflation is transitory, but inflation remains stubbornly high, the Fed may be forced to raise interest rates rapidly down the road to slow down the economy. This might feel like slamming on the car brakes while speeding down the highway. On the other hand, if the Fed tightens too quickly, it risks choking off the recent economic recovery.

So far, the Fed has demonstrated flexibility in its thinking. During its June policy meeting, it upgraded its forecast for economic growth and inflation. And it collectively expects two rate hikes in 2023, up from none anticipated in its March meeting.

So, what’s our take?

It looks to us that inflation levels will come down from current readings. We agree that some meaningful amount is temporary.

That said, we also expect inflation to remain at or above 2%, on average, for the foreseeable future. Last year the Fed made a subtle but important change to its inflation-targeting policy.

Instead of targeting inflation at 2%, it now looks to target inflation at an average of 2%. This is intended to make up for years of undershooting its previous 2% target.

We take the Fed at its word here. The target also aligns with the Fed’s other goal of returning employment to pre-pandemic levels. There’s more work to do there.


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James Walden, CFA

As a partner and the firm’s Chief Investment Officer, James Walden strives to maximize our clients’ long-term, risk-adjusted portfolio returns. This includes determining strategic and tactical asset allocations, as well as specific investment analysis and prudent rebalancing. Jim is also a partner and management team member. His expertise includes advanced investment research and valuation, and he is passionate about his role in helping clients reach and exceed their financial goals.