Sources: Bureau of Labor Statistics, WTIA. Data as of April 30, 2021.
We think “transitory”
The main question for investors is whether the acceleration of inflation will be “persistent” and continue to run hot into 2022, or if it will be “transitory,” and slow down. If the former, the Fed would likely need to get more aggressive and tighten monetary policy more quickly than expected, possibly hiking rates by mid-2022. We believe it will be transitory, with inflation slowing in 2022, for three reasons:
Pandemic and stimulus are one-shot deals
Much of the inflation for goods and housing are one-off impacts. The massive spending done to fortify homes for the quarantine environment, such as new decks, patios, swimming pools, and exercise equipment, will abate as the economy reopens. Additionally, the last round of stimulus checks is out the door and will have diminishing impact as they are spent more slowly over the coming months.
The best cure for high prices is high prices
Suppliers are already responding to high prices by increasing production, which we expect to bring down prices. Construction materials are an excellent example, where producer prices were up 13% y/y through April, the highest since the 1970s. Firms are responding, and industrial production of those materials is up 16% y/y, an all-time high. There are supply chain issues, but we expect those to be managed over the course of 2021.
Wild swings in commodity and producer prices are nothing new and are much larger in magnitude than end prices for the consumer, as shown in Figure 2. Prices for raw materials soared 58% y/y through April (magenta) and those gains are feeding through to the intermediate prices for making consumer goods (orange) and are now beginning to pull up on the prices facing consumers. Our analysis shows a tight historical relationship, with about 15% of raw materials increases flowing to the intermediate goods, and about 40% of those prices going to consumers. If these magnitudes hold, the 58% would translate to 3.5% for consumers. The actual figure in April was quite close at 4.5%, the highest since 2011.
There are plenty of signs that price increases are meeting their limits, with producers or consumers balking at price tags. Lumber has been the proverbial “poster child” here, with prices on commodities exchanges rising from $360 per 110,000 board feet (about one rail car’s worth) to a peak of nearly $1,700 in early May before falling 25% to $1,300. Prices are still high relative to history, but with new construction slowing and lumber companies investing heavily to bring on new production later this year, we expect a sharp deceleration of commodity prices, which will then flow through the economy to consumers.
Productivity—making more with less
The final reason we expect inflation to cool in 2022 is increased productivity by firms, a topic we covered in detail in our annual Capital Markets Forecast. Firms in both the goods and services sectors have greatly increased their productivity over the course of the pandemic. Even though the economy is reopening, restaurants will not “forget” how to take an online order on their new apps, and hotels will continue to use their more efficient booking and check-in methods. Manufacturing output is just 1.6% below the pre-pandemic peak even though employment in the sector is down 8%. As the economy decelerates in 2022, we expect these more efficient firms to engage in competitive pricing to gain market share, putting a lid on future inflation.
Figure 2: Producer and consumer prices (% y/y)