facebook twitter instagram linkedin google youtube vimeo tumblr yelp rss email podcast phone blog search brokercheck brokercheck Play Pause
Understanding Inflation Thumbnail

Understanding Inflation

Ken Blazick, Chief Investment Officer

Stocks rallied last week due to many factors, but inflation, in particular, seems to get the most attention anywhere you look. Wells Fargo senior economist Tim Quinlan was recently quoted as saying "for the past year, inflation has been high and rising and we're at a point now where it's high and falling,"1 which captures the consensus view of many analysts in the media.  Painting the picture for investors that peak inflation is behind us, we have begun the process of "normalization."  The opinion of our Investment Policy Committee is that this view could turn out to be a bit short-sighted.

Before I go any further, let’s define inflation in simple terms.  Inflation is nothing more than more money chasing after the same number of goods or when demand is more than supply.  This mismatch in supply and demand causes the price of goods to rise until the supply matches the demand.

For example, imagine ten people show up to a farmers’ market, all looking to buy one apple and having $1 in their pocket. The apple vendor just so happens to have exactly ten apples for sale. From a market perspective, there is $10 chasing ten apples.  In this case, to match supply with demand, each apple will cost $1. Taking this example one step further, now imagine that the same ten people show up to buy an apple with $2 in their pocket and the same vendor shows up with ten apples.  We now have $20 chasing ten apples in the market.  Now, to match the old supply of apples with the new demand, each apple costs $2.  Voila, Inflation!  To bring this overly simple example full circle, the obvious way to fix this inflation is to take away the extra dollar given to the ten people looking to buy an apple. Once that happens, the market is back to $10 chasing ten apples, and the price of an apple is back to $1.

The real-life economic picture is vastly more complex than that example, but it demonstrates the inflation issue from a high level.  More accurately, instead of ten people buying ten apples, the US has hundreds of millions of people looking to purchase trillions of dollars’ worth of goods and services. During the pandemic, the government injected the same number of people with trillions of dollars of money in a successful effort to increase the demand for goods and services.  The additional dollars in the system successfully increased demand, which has led to increased prices.  The Federal Reserve can work to take the additional dollars out of the economy through short term interest rate increases and open market operations so the supply and demand dynamics can go back to "normal", but the process is a slow one and will not happen overnight.  

The problem with this "fix" is that it does not account for the labor piece of the supply and demand dynamic. Labor will be the fly in the Fed's ointment the longer inflation lasts.  Academically, when inflation is only for one day at a farmers' market, or even as a one-time injection of cash into the real economy, the effects are generally quick but not long-lasting.  However, when inflation persists over an extended period, supply and demand dynamics also begin to take hold in the labor market.  Wages and benefits increase so that workers can afford the higher prices of goods and services.  Once businesses raise their employees' wages, it pays for those raises by increasing the prices of their goods and services. Following the price hikes, the employees now need another raise to compensate for even higher costs of goods and services. Economists call this the "wage spiral." We believe the potential "wage spiral" will have the most profound effect on long-term inflation.

In the real world, inflation has persisted in the economy long enough for wages to rise and labor has now become the biggest driver of ongoing inflation. The demand for labor is significantly higher than the supply, which means the labor cost should be expected to rise until the number of open jobs is a closer match to the number of unemployed job seekers. Specifically, the US currently has 5.9 million unemployed job seekers and 11.4 million jobs that need to be filled, equating to roughly 1.9 job openings for every person looking for a job.  Even in labor markets, supply and demand need to come into equilibrium for stable prices.  Until we get closer to that equilibrium, the costs of producing goods and services will likely continue to rise, and in turn, inflation will persist.

When it comes to the future predictions on inflation, we believe that The Fed, supply chain issues, and the war in Ukraine certainly will continue to play a role, however, we believe that the labor markets are a significant driver and a very important signal to watch.   My goal here was to help explain what is happening with inflation and what we are watching.  None of this is meant to scare you about inflation – it’s only one of countless factors currently influencing the markets.  As always, sticking to the bucket strategy using a well diversified portfolio will help you through all of this economic uncertainty.  Rest assured our talented money management team is constantly monitoring all economic data as it comes in, ready to make adjustments to portfolios based on new risks and opportunities whenever and wherever they present themselves.