Is inflation transitory, or here to stay? Will we go back to the inflation of the 1970s, or will we revert to the good old days of low inflation we’ve seen for the last 20 years or so?
Of course, nobody knows for sure. A number of competing factors are pulling price levels up and down, and we will discuss a few of those here.
The Fed insists that inflation is temporary, and one reason for this is “base effects.” For example, if something goes from 100 to 90, and in year two, it goes from 90 back to 100, the year two report will show an increase of over 10% year-over-year. Yet saying the thing went up 10% last year belies the fact that the two-year return is zero in this example. Since all economic measures were depressed in 2020, the Fed is making the case that these higher inflation points are just the economy catching up from those levels.
Things feel more expensive these days, but there are some indications that the Fed might be right. Lumber prices shot up about 50% during and after 2020 due to intense short-term supply and demand factors. However, standing timber prices only went up a little bit during the same period. As more sawmill capacity comes online and demand retreats from the housing frenzy of the last year, lumber prices should fall to more typical levels. We’re already seeing that today—though prices are still high, lumber futures have almost halved in the last month.
If this inflation truly is transitory, then the specter of deflation could be on the horizon. The unique ways in which Congress, the Treasury and the Fed have supported the economy means that the endless stimulus won’t necessarily flow directly into consumer pockets and higher prices. Many of the Fed’s mechanisms of support only cause banks to have the ability to lend more, which doesn’t help much if nobody is borrowing.
Deflation can cause just as many problems as inflation, and the Fed fears it enough that they are willing to err on the side of a little too much inflation rather than not enough.
Probably the strongest reason to plan for more inflation down the road is the sheer size of the US debt. It has hovered around 100% of GDP since 2012 and has jumped to 130% in Q1 of this year. It’s unlikely Americans will support higher taxes or cuts to government programs, so the easiest way to address the debt in the future will be via a combination of low interest rates (smaller interest payments on treasuries) and higher inflation (make the dollar value of the debt smaller in real terms). This can work, but too much of this formula can put the dollar itself under pressure.
What’s important to know as a Telarray investor is that we are prepared for inflation uncertainty. Note that we said uncertainty–not just rising inflation.
We don’t presume to have all the answers, but what we have done is set up our portfolios to do well in a variety of market environments. We have value, small cap and emerging exposure, which does well in rising inflation periods with steep yield curves. We have bonds and large cap exposure that tends to do well in falling inflation with flattening yield curves. We have international and emerging exposure that should do well if the US market falters or the dollar comes under increased pressure.
The magic of all this is the process of rebalancing, which means we’re constantly taking money from rising assets and reinvesting in out-of-favor sectors. We believe there is a path to a secure financial future for our clients in a wide array of future inflation outcomes in the coming years. Fortunately, they don’t require us to predict the future.