Inflation has been absent from the economic scene for decades. Now, there is a growing concern inflation will increase significantly, hindering economic growth and risk-based asset prices. Historically, the economy and financial markets have a love/hate relationship with inflation. While some inflation is good for the economy, allowing companies to increase prices and wages, spiking inflation can cause consternation in the markets.
Inflation may rise due to:
“Good inflation” is considered steady, moderate increases to the inflation rate that occur due to an expansion of economic activity. When an economy is emerging from a recession, it is not unusual for the demand for goods and services to expand faster than the system’s ability to produce. In this scenario, inflation will begin to rise after a period of rapid economic expansion – such as we’ve experienced with the reopening of our economy. In this context, a moderate increase in inflation is considered positive.
If inflation moves slowly higher and appears to be controllable, it won’t disrupt the outlook for the economy and financial markets. In fact, the economic expansion should be accompanied by job growth and rising wages. If, however, inflation pushes higher into a pattern that appears to be volatile and uncontrollable, then we would tumble into the area of “bad inflation.”
For broad measures of inflation to move sustainably higher, we would need to have wage growth above 3.5% for at least one year. For this to happen, the employment gap would have to be closed. Today, there are several million Americans who have dropped out of the labor force, and the U.S. unemployment rate, at 5.9% in June, is still well above normal levels. Until idle workers are brought back into the labor force and the jobless rate is pushed meaningfully lower, it will be unlikely that we will see enough wage pressure to generate sustainably higher inflation.
Currently, nearly 60% of small businesses are citing difficulty finding qualified workers, making this their top concern, according to the National Federation of Independent Businesses. This can cause temporary inflation as companies compete for employee talent.
Historically, inflation below 4% is associated with stable economic outcomes. Even if inflation rises and interest rates are pushed higher, as long as inflation remains below 4%, and the Federal Reserve’s response is measured and reasonable, it is most likely that any damage to the markets will be short-term.
For inflation to reach the critical 4% level, we would need to see:
The Fed and inflation
The Fed plays an important role in creating or squashing inflation. In many previous cycles, the Fed has been blamed for allowing the economy to overheat due to overly accommodative conditions that are left in place too long, thus allowing inflation to increase and eventually curb growth.
In this cycle, the Fed is implementing a new experiment. Officials are openly communicating they are trying to orchestrate a meaningful overshoot with inflation and remaining historically accommodative until we see inflation, well above their long-term target of 2%. In this experiment, we may learn if the Fed can easily control inflation.
We’re back to the love/hate relationship. The economy welcomes some inflation, contributing to growth, yet dislikes spiking inflation that creates instability. In this cycle, monetary growth has not been moderate; it has been unprecedently robust, perhaps temporarily creating an unstable economic situation. We think the inflation caused by monetary growth will subside eventually. Furthermore, the inflation caused by supply chain disruptions due to COVID-19 should dissipate rapidly as the global economy completely reopens. The most likely outcome is roughly six months of strong inflation, followed by a stabilization at slightly higher than normal rates.
It could then grind higher during the next few years, forcing the Fed to raise rates. But we believe the move to higher rates will most likely be controlled and steady, preserving economic stability.
Eric Kelley is the managing director of fixed income for UMB Bank. He can be reached at firstname.lastname@example.org.
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