People are concerned. Prices of nearly everything seem to be rising rapidly. Did we just turn an inflationary corner? Have two decades of globalization and imported disinflation finally run their course? Is the 20+% increase in money supply during Covid creating excess demand? Are minimum wage laws trickling up wage inflation? Each of these, in our opinion, is at least partially correct and on target. We don’t forecast economic data or prognosticate anything, but inflation and whether or not it will persist is a risk that is worth discussing more fully.
The Covid pandemic created a lot of global supply-demand imbalances that we believe are temporary in nature. These temporary imbalances aren’t likely to translate to meaningful long-term declines in purchasing power. But other structural changes may or may not have long term impacts. Please bear with us while try to separate the temporary from structural and lay out some of the risks that concern us and those that don’t.
The Temporary – this, too, shall pass
News headlines sharpen our perceptions, highlighting spots where prices are soaring. Steel companies raised and keep raising prices to meet surging demand, lumber prices have nearly tripled off the bottom and finding good wood is challenging. Home prices continue to post new highs. Much of this is because the supply chain of nearly all physical products was upended in the last year and it is taking a long time to return to normal business cadences. The IISI steel production index, for example, is still 14% lower than at the end of 2019 while their price index is 35% higher. Wood production and the number of home sales are all well below levels seen just in 2019. The inventory of homes available for sale is actually quite low, forcing the bidding wars you’ve heard so much about. In the longer run we firmly believe that all markets eventually find clearing prices. We also know that temporarily, anything can push well above or below longer-term supply-demand driven levels before returning balance.
As for goods and commodities, unless you are part of a cartel like OPEC+ or perhaps a truly differentiated brand, long term control of industry supply is generally impossible. Competitors will eventually rush to fill production gaps if you pursue a high price rather than high volume approach. That’s the magic of an almost fully competitive economy.
Freight and logistics are simply a mess right now. With cargo ships stacked in many of the world’s major harbors, shippers of imported goods can’t even find containers. Long delivery delays and excess “rush pricing” drive the perception that consumers and businesses should buy goods now to have any hope of getting them soon, particularly if they go “on allocation”. The most salient risk here is that of multiple-ordering where purchasers don’t just order early, they order often, assuming that they will receive 1/3 or ½ of their original order as customers get rationed.
If you look back to ‘90s tech boom you will recall the deflationary pattern that followed the boom times that led to rationed orders. Companies who did not realize customers were gaming the system or placing orders with multiple suppliers falsely assumed that they needed more capacity until demand returns to normal. Over the past several weeks, semiconductor makers publicly announced plans to spend $150+ bln to increase capacity in coming years, not to mention another $50 bln of federal semiconductor-oriented investments embedded in the large infrastructure bill before congress. For reference, overall capacity utilization in the US has fallen from 82% in 2000 to about 74% today, still five full points below
pre-covid 2020 readings. Much of we what we see is disrupted supply chains and uneven manufacturing cadence.
The Structural – Maybe Not Temporary…
The Federal Reserve has publicly stated that they will look through the temporary issues we pointed to above. They intend to keep interest rates low through 2023, let the economy run hot for a while and aim to get unemployment back to a lower level. They struggle with a shrinking work force, fiscal policy that may discourage work, and with a fairly sudden reversal of many public policies that restrained spending in restaurants and other amusement for the past year. Again, most of that is temporary.
But isn’t it true that a jump in money supply will immediately bring higher prices? Venezuela? Weimar Republic? That’s a rational thought if everything else, particularly the propensity to spend that money is steady. But what if people get money and then hold onto it, preferring to have it rather than worrying about it buying less tomorrow? Perhaps that was enforced Covid austerity, or perhaps many have built their first rainy day fund. Money velocity, the number of times a dollar changes hands in a year, has fallen rapidly in recent years. Very loosely, $1 tln of new money represented $2.2 tln of economic activity in 1995 and $1.1 tln today. Or differently, $16 tln of pre-covid M2 created over $22 tln of activity but because velocity fell so sharply, $19.3 tln of M2 is generating only $21.5 tln of activity today. One part of that equation will change, but it’s not clear which one.