As we discussed yesterday, the current inflation data simply is not that scary. Yes, there are signs of inflation, and the most recent numbers were startling. But when you break down those numbers, take out the pandemic effects, and normalize over a longer time period, inflation is pretty much where it was in 2018 and 2019.
Why the media reaction, then? Yes, it was a startling inflation report, but much of the coverage was driven by very real trends that could well lead to higher inflation ahead. We shouldn’t panic about the short term, but we do need to take a harder look at those longer-term trends. Even though this most recent report was not principally about them, those trends are real. When we move on from talking about today’s inflation to next year’s, those are the trends we need to keep an eye on. So, what are they?
A big part of the stories out there is a labor shortage and consequent wage inflation. One of the core assumptions in American business is that there is a virtually inexhaustible labor supply, at or close to minimum wage. In many markets, that assumption is being challenged, with many companies being forced to raise their pay well above the minimum. Arguably, this shift is due to COVID; many people are reluctant to return to work, which is artificially suppressing the available labor supply. This is the assumption that is driving many states to eliminate the supplemental federal unemployment payments that make it more lucrative to stay at home. That move will probably work, and in any event, the federal payments expire in September. But what if it doesn’t?
With large parts of the boomer generation unlikely to return to the workforce, with other formerly reliable labor sources such as immigration under attack, and with the millennials aging out of junior, lower-wage jobs, it is very possible that lower-wage jobs might have a much tougher time getting filled. I will be watching the participation rates and employment cost indices closely through the rest of this year to see if this really is an emerging risk.
Supply Chain Problems
Another reliable source of headlines is supply chain problems, for everything from simple commodities like iron to complex manufactured goods like electronic chips. Here, too, the core assumption has been that supplies of everything will be generally available, although the cost may vary. Just as with labor, that assumption is now not working, and shortages are driving costs—and inflation—up.
Here, I think the problem is probably shorter term than the labor question, as miners and manufacturers can drive up production in fairly short order, while producing a new worker takes at least 16 years due to child labor laws. And while that statement is a bit flip, it is also accurate. Commodity producers can scale up production in the short term and open new mines in the longer term. Manufacturers can add new shifts or assembly lines in the short term and build new factories in the longer term. These are solvable problems, in terms of the amount of production. But how quickly they can be solved is a real question. Again, this is something that I will be watching through the rest of the year. How quickly can we normalize? And what effect is that having on the economy?
Note, though, that I was careful to say we could solve the production problem. But I did not say anything about cost. This is the real inflation threat going forward, and it is one that touches both of the above points. Even if the world economy remains integrated, China’s labor force is now shrinking, so there will be more labor constraints going forward. Labor costs may not be forced up, but they will not be declining either. And, if relations between the U.S. and China get worse, we could see companies forced to reshore operations here, which will worsen any labor shortages in the U.S. and certainly drive up relative costs.
The same holds for commodities and manufactured goods. A substantial portion of everything we consume is sourced and made abroad because it is cheaper and more efficient to do it there. If and when globalization starts to turn, costs will go up and efficiency will go down—and that could drive inflation here higher. This is likely to be a slow and multiyear trend, but there are signs it is already starting. This risk, too, is something I will be watching.
Trends Are Changing
The current spike in inflation is likely to fade. But when we look at the bigger picture, we can see that the many tailwinds we have had over the past decade that kept inflation low are likely to reverse and that inflation over the next 10 years will very probably be higher than the past 10 years. That does not mean we are moving back to the 1970s, of course, much less to hyperinflation. It is something to watch.
For that reason, the current inflation spike—while due to pandemic effects—is a great opportunity to think through how the world is changing and what that means for your portfolio. Don’t panic about inflation. Do use this time to think through where you are now and where you want to be as things change. Because they are changing.