Inflation: Is it here to stay?

Tawfik Jaroudi

Tawfik Jaroudi

Sep 9, 2021 – Industry Intelligence Inc.

September 9, 2021 () –

In the wake of the pandemic, the US government pursued an expansionary monetary policy in the hopes of stimulating the economy. Interest rates have been cut to historic lows. Furthermore, US$80 billion worth of Treasury securities and US$40 billion of mortgage-backed securities have been bought by the Federal Reserve every month since July 2021.

Why is inflation so high?

Initially, as COVID forced people to confine to their homes, unable to enjoy outdoor entertainment and services such as theaters and restaurants, consumers instead spent their money on non-essentials online. This trend was evident by the outperformance of Consumer Discretionary stocks compared to others in the S&P 500, except for Technology stocks. However, as of the end of June, the sector has been one of the worst performers, with only Energy and Industrials lagging. Following the reopening of the economy, funds flowed to goods and services that were previously out of favor due to lockdown and supply-chain disruptions, such as Housing, Travel, Transportation, and Tourism. The pent-up demand and lack of supply caused prices to soar and inflation to exceed 5%.

Is inflation here to stay?

It is worth mentioning that different age groups view the risk of inflation and its effect on them differently. Baby Boomers are more fearful of the impacts of inflation than Millennials and Gen Z. For starters, they had a negative experience with inflation in the 1980s, which is why about three-quarters of Baby Boomers believe inflation has hurt their finances. On the other hand, only slightly over half of Millennials shared the same sentiment. This disparity is because Baby Boomers do not have the time Millennials do to financially recover from the adverse effects of inflation on their savings, especially retired ones.  

This surge in inflation may be temporary, as it has affected some sectors and businesses more than others. Supply shortages and high demand in various industries were the catalysts to the dramatic increase in prices once economic restrictions began to ease. However, the decrease in the 10-year Treasury Bond yields since Spring indicates that the bond market is not apprehensive of inflation in the future, further supporting the idea that these elevated inflation levels are transitory. Fed Chair, Jerome Powell, believes the 67% decline in lumber prices from their May high of $1,700 is a sign that the inflation is temporary, and that prices of other goods and services will soon follow suit. Used-car prices experienced a severe decline in their growth rate (0.2% vs. 7.3% in all three prior months), while airline tickets prices saw a slight decrease.

However, inflation's direction and its potential effects could be more pronounced and longer-term than expected. According to a New York Federal Reserve survey based on 1,300 households, consumers expect inflation to remain at elevated levels. Also, a University of Michigan reading of consumer sentiment declined to a low not seen since 2011, reinforced by a decline in consumer spending of 1.1% during July. The negative market sentiment coincides with disappointing second-quarter retail sales, translating to an increase in short equity positions. Short-sellers accounted for about 4.6% of the security positions in Consumer Discretionary securities during August, more than any other sector, and nearly double the S&P 500 short interest to total shares outstanding ratio. Among the five most shorted company stocks during August, three were Consumer Discretionary: Big 5 Sporting Goods, Workhorse Group, and Blink Charging. Is the negative sentiment warranted, or is the market overreacting? Is the market overheating? Are these price increases permanent? The presidents of the St. Louis Fed, Philadelphia Fed, Dallas Fed, and economist Mohamed El-Erian believe the Fed's timeline for tapering is too slow, supporting a more urgent one.

Looking ahead: Delta, CPI, and the Fed

There are several uncertainties to consider when trying to forecast the next steps the government will take regarding inflation. Their critical focus is maximum employment and a decrease in the inflation rate to near 2%. The July inflation reading posted a significant increase of 5.4% year-to-year, compared to a more muted increase of 0.5% month-to-month, potentially the start of the inflation rate's return towards the 2% target. Perhaps the August CPI reading will clarify the economy's potential direction and the Fed's future policies. When deemed appropriate, the economic approach will become a contractionary one. The Fed will scale back security purchases to address inflation, followed by rate hikes, should the job market continue its positive trajectory with employment rates. However, uncertainty lingers regarding the timeline, which could prolong and exacerbate the risks of heightened inflation into 2022, should it not be addressed correctly. How the Delta variant will affect the economy and job market remains uncertain. Still, it poses a threat as infection rates have been rising while vaccination rates have been declining. However, it is the elevated inflation rate that has many worried about the future of the economy. According to Moody's Analytics, heightened fears of the Delta variant leading to a decline in dining out and travel could relieve some inflation pressure. However, according to Goldman Sachs, it appears that such changes in consumer behavior have not yet been significant enough to have a material impact on prices. Nevertheless, more market changes may come soon, as the weekly US$300 Federal Unemployment benefits expired on Labor Day.

Tawfik Jaroudi is the Economy and Real Estate analyst for Industry Intelligence, which can help YOU better address your own industry challenges. To arm yourself with the latest market intelligence, contact ClientCare@IndustryIntel.com. Ask us about our interactive intelligence map and search bot on Microsoft Teams.

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