A lot of people, perhaps even too many people, are talking about inflation.
I say this because when there’s so much attention on a topic, you have to wonder if it’s being overhyped, or if maybe there’s something more to it.
Various inflationary factors are starting to appear. Recent U.S. government reports show signs of rising prices at both the consumer and producer or manufacturing level. The Consumer Price Index (CPI) was up 5.3 per cent annually, the highest in 13 years, and the Producer Price Index (PPI) was up 7.3 per cent, the highest in over 10 years.
Some are suggesting the next Roaring 20s as the negative effects of COVID come to an end and all that pent-up demand and money goes flying through to the system. The stock market seems to be acting that way and with interest rates still near historic lows, stocks could move higher still. Others talk about another inflationary era like we saw in the 1970s. Many analysts are also pointing out that businesses say that it’s hard to find employees and that wages are going up.
When it comes to commodity prices, the one-year price change of the U.S. commodity component of the Producer Price Index is up 19 per cent, rivalling historical annual increases of around 20 per cent. That’s an impressive increase, but will these higher commodity prices continue to work themselves in to the industrial cost structure as measured by the PPI and then ultimately the CPI? Based on St. Louis Federal Reserve data and analysis, there is “a strong positive relationship between oil prices and PPI inflation. Higher oil prices are associated with higher producer prices and vice versa. Specifically, the correlation between oil prices and the PPI is 0.71. This strong link likely comes from the importance of oil as an input in the production of goods. In contrast, there is a positive but much weaker relationship between oil prices and CPI inflation: The correlation is 0.27, much lower than for producer prices. This weaker link between oil prices and consumer prices likely comes from the relatively higher weight of services in the U.S. consumption basket, which you’d expect to rely less on oil as a production input.”
So the question remains — are we in a long-term commodity supercycle that will eventually feed in to producer and then consumer prices? What we do know is that despite this recent runup in prices, commodity prices really haven’t moved that much in the last five years, especially compared to previous five-year periods. The accompanying chart shows that the commodity component of the Producer Price Index can rise by 50 per cent over the course of a five-year period. So whether the current situation is just a short-term, one-time spike or if it develops into a longer-term five- or 10-year trend will be key.
As a final note on inflation, even with governments stoking concerns with all the money created around the world in the past year and central banks talking inflation targets, it doesn’t mean consumer prices will increase.
Take Japan as an example. In January 2013, moore than eight years ago, the Bank of Japan set its price stability target at two per cent in terms of the year-on-year rate of change in the consumer price index (CPI), and has made a commitment to achieving this target “at the earliest possible time.” Despite this commitment and massive amounts of money creation as well as government spending, their CPI has averaged just 0.7 per cent in the past eight years since the announcement. Japan is still a very long way from their two per cent inflation target.
Japan isn’t the only central bank with an inflation target. Likewise, in January 2012, the U.S. Federal Reserve announced an explicit inflation target for the first time in its history, stating, “that inflation at the rate of two per cent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.” This inflation index has measured only 1.4 per cent on average since then. Also, the European Central Bank’s new strategy allows it to tolerate inflation higher than its two per cent goal when interest rates are near rock-bottom levels, such as now. This is meant to reassure investors that policy won’t be tightened prematurely and boost their expectations about future price growth, which has lagged below the ECB’s target for most of the past decade. As we can see, governments can’t just decree growth or two per cent inflation so inflationary pressures may or may not actually develop over the next few years.
Bottom line, while headline inflation numbers are getting a lot of attention lately, it doesn’t mean we’ll have wage inflation or 1970s stagflation or a growth-induced inflationary environment; no one knows for sure how this will all unfold. But, a couple of months ago, I wrote about how prices of real physical assets like land, houses, stocks, private businesses, condos, cottages and vacation properties prices have been increasing.
It is likely that this real asset inflation continues, especially with low interest rates and the massive amount of money creation we’ve just witnessed. However, it’s not as evident that price inflation of all the goods and services we buy every day will come true.