Inflation: What’s driving prices higher?
Inflation is the year-over-year increase in prices for consumer goods and services. Understandably, inflation often elicits a negative response. Let’s be honest, do any of you shout “Yes! Prices are rising!” while high-fiving fellow shoppers at your local retail checkout line? But from an economic standpoint, inflation isn’t an inherently bad thing. Rising prices typically represent a vibrant consumer demand for goods and services that ultimately drives our economy forward.
However, the key word is moderation. Historically, the U.S. Federal Reserve’s target rate of inflation is 2%. The Fed deems a 2% inflation rate as the ideal balance between economic growth and rising prices. The Fed serves as the decision-making body for U.S. monetary policy. By adjusting its monetary policy, it seeks to manipulate spending, investment, employment and inflation to promote economic growth.
But consumer prices have been steadily rising since early 2021. The Department of Labor’s Consumer Price Index recently reported that consumer prices in April surged by 4.2% over the past 12 months. This was the fastest pace since September 2008 and well above Wall Street’s forecast of a 3.6% rise.
A number of factors are behind this spike in prices. Global supply chains of materials and component parts have yet to fully recover from pandemic-related shutdowns. These disruptions have constrained manufacturing output while increasing the cost of limited supplies available. According to the National Association of Home Builders, the current shortage in lumber has added nearly $36,000 to the construction price of an average singly family home. Ford Motor Company is one of many manufacturers facing a global shortage of semiconductor chips. As of March 31, Ford had approximately 22,000 finished vehicles simply waiting for computer chip related components. On Wednesday, Ford announced a series of plant shutdowns.
Government stimulus measures have also pumped nearly $6 trillion into the U.S. economy, bloating our nation’s money supply. In February, the M2 money supply had increased by 27% over the past 12 months, the largest one-year gain since 1943. The M2 money supply represents the total amount of U.S. currency in circulation plus cash held in bank accounts, CD’s and money-market investments. The rate of increase in the M2 has declined slightly to 24% but still represents a mountain of new cash flooding a vaccine-fueled economy that will drive prices higher.
In response to the pandemic, the Fed will now allow inflation to run above its 2% threshold. Historically, when inflation approached 2%, the Fed would start raising the benchmark fed funds rate, upon which short-term debt is often based. Higher interest rates increase the cost of borrowing which inherently reduces consumer spending. The Fed’s goal is to gently tap the breaks on the economy and inflation to prevent the economy from overheating and consumer prices from soaring too high. But to help boost the economic recovery, the Fed has indicated it won’t start raising interest rates until at least 2024.
For the full-year 2021, the Fed projects inflation rising to 2.2-2.5% – a mild form of inflation. It views the current inflationary pressures as short-term, caused primarily from disruptions to global supply chains. Once these supply chain issues become resolved, inflation will quickly return to its 2% target rate. Thus, there’s no hurry to start raising interest rates.
But Wall Street has a different take on inflation. Yes, they agree the supply chain disruptions are temporary. But many argue the Fed is not fully considering the inflationary pressures from the massive increase in the M2 money supply. In their view, the government can’t increase the money supply by 24% without causing significant, long-term inflation. Instead, inflation should exceed 3% this year and reach 4% by 2022. Consequently, the Fed will be forced to start raising interest rates and adjusting its monetary policy much sooner than expected.
It’s too early to tell which side – the Fed or Wall Street – is right on the path of inflation. But the betting money-line is gradually shifting towards Wall Street. Americans might need to brace for even higher prices, and eventually, higher interest rates.
Mark M. Grywacheski, Investment Advisor
Opinions expressed herein are subject to change without notice. Any prices or quotations contained herein are indicative only and do not constitute an offer to buy or sell any securities at any given price. Information has been obtained from sources considered reliable, but we do not guarantee that the material presented is accurate or that it provides a complete description of the securities, markets, or developments mentioned.
Quad Cities Investment Group, LLC is a registered investment advisor with the U.S. Securities Exchange Commission.
