The Inflation Debate

The Inflation Debate

May 27, 2021

We are now more than a year beyond the start of the pandemic and six months beyond the election.  As markets hit highs, the economy rebounds, and policy takes shape, one word has recently dominated the headlines: inflation.


A certain amount of inflation is a good thing and occurs naturally during an economic recovery (reflation).  The pandemic caused deflation, or a drop in the general price level, so reflating as the economy reopens and expands is both healthy and expected.


The Fed’s view

The Fed has termed the recent rise in inflation-related data as “transitory”, attributing the uptick to the rapid recovery and temporary supply chain issues, as opposed to a more prolonged period of price increases.  If correct, this would keep with Fed policy to raise rates at the end of 2022.  If not, we could either see higher than expected inflation or a policy shift.  This is the point of intense debate among Wall St. firms and economists alike.


One of the primary metrics the Fed monitors is the Personal Consumption Expenditures (PCE) Index.  The most recent release was 1.74% and economists note that a policy shift would likely occur at 2.8%.  With current unemployment above 6%, the fed has room to let the PCE run higher.




Consumer spending and pent-up demand?

Given that the American consumer is the largest economic driver, it will be hard for the economy to overheat without outsized consumer spending.  Americans have been saving in greater amounts than in the previous 30 years.  If inflation is to take hold from demand, it would require a significant swing in consumer spending to the point where demand persistently outstrips supply, driving up prices across most goods and services.  Recently, excess consumer demand has been focused in specific areas such as travel, leisure, and autos.  These are the same items that saw sharp price declines last year.  Autos alone accounted for over a third of April’s inflation uptick.



A delicate balance

The heightened attention around inflation stems from the unprecedented nature of this recession and recovery.  During the pandemic, the Fed and Treasury injected trillions into the system through direct payments, spending, and lending.  At some point, measures must be taken to sop up the excess in a system awash with liquidity.  The Fed must be on target with its timing.  A move too early risks stunting the economic recovery, increasing unemployment, and lengthening the recession.  Moves too late could mean high inflation, requiring sharp, definitive measures to be taken, throwing the brakes on the economy instead of just slowing it down.  It is a complex dance between government policy, fed policy, supply chains and consumer spending.  While the data suggests we are still in an appropriate forecasted range, these variables are impossible to predict.


Real returns over time

Gold is NYM $/OZT Continuous Futures Close. Inflation adjustment is US CPI base 1982-1984. Prices are indexed to 100 to facilitate comparison.


We have consistently invested in equities and real estate to generate long-term real returns.  There are many asset classes making headlines such as TIPS.  TIPS are most effective when inflation is unexpected. TIPS yields are currently negative in real terms, so investors would need inflation over 3% to likely earn a real return.  We believe that if such an inflationary jump would occur in this environment, it would likely be catalyzed by robust economic growth, which in turn would fuel company earnings, equity markets, and real estate. For those reasons, we continue like our current positioning, yet are consistently evaluating alternatives should an opportunity arise.  While past performance is not a predictor of future performance, we believe that our long-term viewpoint and disciplined process have you well positioned for the future.


All data sourced from FactSet as of 5/17/2021.