Economic Reflections

Disentangling Inflation

by | Feb 10, 2022 | Economic Reflections

Pandemics have existed throughout history, yet in many ways, it seems we felt we were immune from such calamities given our lack of preparedness. Since the occurrence of the Spanish Flu in the early 1900s, there has not been a pandemic of such scale in modern times. Covid-19 struck without warning and fundamentally changed the way we live and what we value forever.

The initial outcome may have been different if there were a global, coordinated effort during the rise of the pandemic. However, many countries chose their own path resulting in differing outcomes. The global economic lockdowns initially crippled economic activity in 2020, while monetary and fiscal stimulus measures mitigated a deep global recession. If vaccine rollouts and monetary and fiscal policy were coordinated, it seems the ability to open-up economies could have occurred much sooner. While much is clearer in hindsight, what matters is where we are now and where we intend to go.

Inflation remains at stubbornly high levels at 7.5% and is less transitory than the Fed anticipated,[1] and at this juncture, it is both a supply and demand issue. The supply-side inflation has largely been caused by disruptions due to the pandemic and bottlenecks as consumers have spent far more on goods than they have on services – reaching 36% of personal consumption compared with 31% in the two years prior to the pandemic.[2] On the demand side, inflation is being caused by a multitude of factors including monetary and fiscal stimulus, a drawdown in household savings, and the wealth effect.[3] To understand inflation’s progression, we need to understand both the supply and demand-side factors.

It seems there is a limitation to the amount of savings households can draw down as well as the propensity to consume – this cannot persist indefinitely. For example, household savings spiked at 34% in 2020 and has now come down to 8%.[4] Also limiting the propensity to consume is the decline in asset prices, with the S&P500 down 8% YTD as of January 31, 2022, which impacts the wealth effect. The Fed signaled in December that they will increase the Fed funds rate in upcoming meetings to combat inflation. This should dampen growth given the higher cost of borrowing as well as the impact on asset prices and the wealth effect. In the current political climate, it seems unlikely that additional fiscal stimulus will occur. Therefore, the wildcard is supply chain constraints due to the pandemic.

While Omicron is more contagious and transmissible, the effects are less severe compared with other strains. This coupled with the feeling that previous measures such as lockdowns will likely be futile, there seems to be a consensus among governments to open their economies despite the higher infection rate. As a caveat, more infections could strain healthcare infrastructure. If there is not a more severe Covid-19 mutation going forward, it is likely that the supply-side constraints will subdue over the course of 2022 and 2023. A major global trade player, A.P Moller-Mask A/S, signaled recently that supply chain constraints may ease in the coming months.[5]

Given these supply and demand-side factors, and consistent with what we wrote in our 2022 Capital Markets Forecast, we expect inflation to peak in 2022 as supply-side constraints ease. The structural level of inflation could be higher than pre-pandemic levels and could remain above the Fed’s target 2% threshold. In such an environment, it is important for investors not to panic, remain diversified, and stick to their long-term asset allocations. We remain Neutral/Positive on Global US Equities, Global Fixed Income Core Plus Bonds, Private Equity, and Private Debt.

[1] Consumer Price Index for January 2022

[2] Wall Street Journal

[3] The wealth effect is the change in spending that accompanies a change in perceived wealth.

[4] St. Louis Federal Reserve

[5] Bloomberg