The bond market has been factoring in the possibility of higher inflation for a number of months. Long term interest rates have increased by 75 basis points (0.75%), the yield curve is steepening (long maturity yields moving up much more than short maturity yields), and Treasury Inflation Protected Securities (TIPS), which are indexed to inflation, have massively outperformed conventional coupon treasury securities.
Commodity prices have been surging across the board. Oil is up over 35% since the beginning of the year, while copper and lumber are up 40% and 95% respectively over the same time frame. Interestingly, in a significant departure from historical precedent, gold, considered to be a solid hedge against inflation over millennia, has declined 5% year to date! However, Bitcoin, which in some investor’s minds has become the new “digital gold,” has seen tremendous – although volatile – growth in recent years.
Paying heed to warning signs
The fundamental force behind these warning signs is the massive amount of monetary and fiscal stimulus, the likes of which the U.S. economy has never seen. Trillions of dollars have been pumped into the system to support consumer demand for goods and services in response to the pandemic.
Meanwhile the pandemic has seriously disrupted the supply of goods and services. Simple economics dictates that when demand outstrips supply, prices will rise. The Federal Reserve (Fed) and other policy experts assert these inflationary impulses will be “transitory” and short-term in nature. Investors should be very circumspect, if not outright skeptical about this perspective. Consumers also appear concerned, with consumer sentiment declining as inflation fears mount.
Certainly, the current environment is unusual given the pandemic. Commodity prices may retreat as economies normalize and pandemic-related supply chain problems become resolved. However, some of these impacts may be long-term in nature. Serious questions have arisen regarding the risk and economic benefits of significantly outsourcing supplies and/or production to “cheaper” countries.
Furthermore, negative political dimensions have become evident as domestic companies assess the risk of foreign governments impacting their supply chains or production processes. These risks were percolating in the “tariff wars” that preceded the disruptive force of COVID-19.
Inflation targeting has proven to be problematic for the Fed, which for the past decade has been unable to consistently boost inflation to its 2% target, missing more than 90% of the time. Now the Fed may be overestimating its ability to precisely engineer and control inflation, particularly given the unprecedented magnitude of the accommodative monetary policy they have been following for many years. Inflation tends to remain subdued until it isn’t, and then it can become non-linear, as inflationary expectations become rooted in the minds and actions of consumers and businesses.
The economy has shown dramatic strength as it moves to “reopen.” Longer term, the main concern is less about commodities, supply bottlenecks or even a spike in demand; it is wages and a tight labor market. Although more than 8 million people remain unemployed, there is now a record number of over 8.1 million jobs that remain unfilled.
Although anecdotal, there are widespread stories of businesses, especially in the service industries, that are challenged in their efforts to reopen given the dearth of respondents for job openings. Furthermore, there is evidence of businesses finally “opening their wallets” by offering higher wages to attract employees. Companies such as McDonalds, Amazon and Chipotle have announced significant increases in average hourly wages, as well as signing bonuses to attract and retain labor. Clearly higher wages are good for the US economy. However, this will contribute to additional inflationary pressures.