At the moment, the topic of inflation is on all of our screens. Politicians, industry experts, & your neighbors are all talking about it right now so what is it and why is it important to watch?
Inflation can get overly complex. There are many different types taught in the academic world, but for most cases, when we say inflation is rising 2% every year, this means that a predetermined basket of goods that we spend money on, now costs 2% more. If our basket of goods for May 19, 2020 was $100 and inflation rose 2%, we would now be spending $102 today (05-19-2021) for those exact same goods.
The above example is a pretty simple concept but calculating true inflation can get tricky. For more complex products there are things we need to adjust. For example, a base Toyota Camry in the year 2000 cost $17,973 (USD). Today the 2021 base Toyota Camry costs $25,045. Over 21 years, this represents an annualized inflation rate of 1.58%. However, the new Camry’s are larger, with a lot more technology packed in. The Hedonic adjustment is used to help economists adjust those additions out of our numbers so we can get a more accurate number of what inflation has been. This would mean the true inflation rate for the Toyota Camry would likely be less than that 1.58%.
Our central banks (learn more about them in my MMM – Duration risk article) try to peg inflation long term at about 2% to 3%. To put it simply, Inflation that runs too hot (Germany after the first world war) or deflation (negative inflation which we saw in Japan) are both dangerous. Our target inflation rate allows us to promote consumer spending while keeping the increase in prices stable and sustainable.
Time For Some Data!
So why is this boring topic all of a sudden so interesting to so many people?
Hot off the press we just received the U.S. year over year inflation numbers, and it came in at a whopping 4.2%! If our long-term goal is for inflation to be 2.5%, this means it is currently 68% above where we want it! These are the headlines that are likely popping up on your screen.
I wanted to make this article to help shed some light on why it isn’t as “doom & gloom” as it seems, and why the numbers you are seeing (and the people promoting them) are slightly misleading you.
To start, there is nothing misleading with the fact that U.S. inflation year over year is 4.2%. The misleading part is that we are focusing on the year over year increase without focusing on the other factors and long-term data. For example, if we go back to last year, one of the main topics (outside of COVID) was that oil hit a low price of below $0 per barrel. So, this year over year inflation data has now seen the data from before the oil price collapse fall off its records and it only encompasses the impressive rise in oil prices thereafter (the price of WTI oil now sits comfortably in the $60’s). You can see this in the above chart. The core price index which strips out food and energy costs has a year over year increase of 3% (which is more in line with what we want to see). This number helps us normalize our data.
Although we were anticipating a larger year over year inflation rate, it did still come in higher than expected. This is at least partially because of the increase in demand that we saw due to consumers receiving stimulus cheques while the world had artificial constraints (lockdowns) set in place. This has helped lead to increased prices in technology, transportation, furnishings, food, housing, etc. This is however, likely a short term issue.
Central banks have communicated at the end of 2020 that they are comfortable letting inflation run a little hotter than normal to help compensate for the undershoots we have seen over the past decade. At some point, however, they will start to increase interest rates to help curb inflation. When this happens, we will likely see increased volatility in the equity markets. It’s important to remember that as long as you are investing in quality companies, paying quality prices and you are sitting within your risk tolerance level, volatility is fine. These fluctuations can even provide our portfolio managers with purchasing opportunities to help our returns in the long run.
Over the next few months, we will likely see further inflation scares. Over the next few years, it is highly likely that inflation will be slightly higher than normal. However, when we look long term, the base case that I see when going through economic reports is that inflation will remain at normal rates.
If you have any questions or concerns, please feel free to reach out to me!