Will continuing inflation kill the recovery?
This spring, I wrote about how consumers and investors alike should prepare for inflation and then two months later, I wondered whether high prices would persist. So far, the answer to that question is a resounding “at least for a while.”
The Consumer Price Index (CPI), which measures what people pay for goods and services, soared by 5.4% in June from a year ago, the strongest annual pace since August 2008, when crude oil spiked above $100 a barrel. The core CPI, which strips out the volatile food and energy components, jumped up 4.5% from a year ago, a 30-year high.
While these numbers are eye-popping, Federal Reserve Chair Jerome Powell does not seem particularly stressed. In his recent testimony before Congress, he said that inflation “has been higher than we’ve expected and a little bit more persistent.” But he also reiterated that the gang at the central bank believe that much of the price surge is due to “transitory” factors.
One argument for a chunk of the price increase being temporary is that the current inflation data compare where we are today with the depressed numbers from the pandemic last year, when the economy shut down and prices plunged. But Powell noted that the economy has run headfirst into a “perfect storm of high demand and low supply.”
He’s right, of course, because as the economy has reopened from the COVID-shutdown, consumer demand is red-hot. With $2 trillion in excess savings, we have collectively ditched our paper towel and disinfectant spending and replaced it with all those fun things we couldn’t do for 16 months, like dining in restaurants, visiting salons and traveling. The big question, according to Capital Economics, “is whether the prices of things like hotel rooms and airfares simply return to pre-pandemic levels or, as we’ve seen with car rentals, whether pent-up demand will cause a temporary overshoot.”
Economists concede that supply chain issues could remain with us longer than they thought earlier this year. Two examples are lumber futures, which have fallen by nearly 70% from the pandemic peak of more than $1,700, but remain well-above pre-pandemic levels, and semiconductors, where a global shortage persists. The latter has caused motor vehicle production to stall and, as a result, used vehicle prices are now a whopping 40% above the pre-pandemic levels.
Adding to the inflationary pressure are wages, which are rising. In a rare, Onion-esque sarcastic headline, the left-leaning Economic Policy Institute wrote, “Newsflash: Higher pay attracts workers.”
While some companies can absorb higher employee costs, others are passing them along to consumers, which economist Diane Swonk of Grant Thornton says could mean that “some of the inflation we are experiencing could linger.”
Even if monthly inflation were to slow from here, price pressures could persist into the end of this year, which could force the Federal Reserve to act sooner, rather than later. The consensus view among investors is that the central bank will begin reducing bond purchases as soon as the fourth quarter. However, if inflation is sticky, there will be mounting pressure for officials to act more aggressively by raising interest rates, which could dampen economic growth. While a rise in rates is unlikely to cause a recession, higher rates could shave growth to around 6.5% or less this year (after contracting by 3.5% in 2020), which would be lower than earlier estimates of more than 7%.