Inflation: Transitory or Persistent?

·3 min read

- By Panos Mourdoukoutas

Inflation, the old villain that battered the U.S. economy in the 1970s, is back, as evidenced by a spike in both the Consumer Price Index and the Producer Price Index statistics released in recent months.

Wall Street has taken notice. Major equity averages have been selling off any time inflation numbers are released, as was the case in the last week when both CPI and PPI came out above analysts' expectations.

Rising inflation leads to rising long-term interest rates, which have several adverse effects on stocks. For instance, raising the cost of borrowing funds, which significantly impacts the bottom line of highly leveraged companies.

Meanwhile, rising interest rates make stocks less appealing to alternative investments like bonds and money market funds. That's especially the case for companies that have no earnings and pay no dividends to compensate for the erosion of the value of their holdings due to inflation.

Eventually, rising interest rates lead to economic growth. That hits the top and bottom line of economically sensitive companies like housing, autos and other sectors that produce discretionary consumer items.

But things do not always turn that way. In most cases, inflation is "transitory." That's inflation arising when economies are in transition from sharp contractions to sharp expansions due to "bottlenecks." These are disruptions and breakdowns of the supply chain of the economy. They cause delayed responses of the economy's supply-side to a rapid expansion of the demand side, which creates shortages and pushes prices higher.

Transitory inflation is usually temporary as price hikes gradually temper off as supply catches up with demand.

What if these bottlenecks persist and the supply side fails to catch up with demand for a prolonged period? Transitory inflation can turn into persistent inflation. That's inflation due to the build-up on the expectations among market participants that the imbalance between the demand and the market's supply side continues for a long time.

That's what happened back in the 1970s, when inflation turned from transitory to persistent.

What kind of inflation is the U.S. economy experiencing this time around? According to Federal Reserve Chair Jerome Powell, it's transitory inflation. Rising prices reflect delays in how the economy's supply side is adjusting to the economic recovery from the Covid-19 pandemic. In this way, the Fed justifies its recent decision to keep its accommodative policy unchanged despite the strengthening economy.

Oxford Economics agrees with the Fed. In April, the analysis company noted, "Inflation is picking up across advanced economies (A.E.s), and emerging markets (E.M.s), but the data suggests this will again prove temporary. We see no signs of lasting pressures that might turn a temporary spike into a lasting overshoot."

The data the report is referring to is the "slack" in the labor market, which keeps wage pressures tamed in the face of fiscal easing. The report noted the U.S. unemployment rate is standing at 6.1%, well above its natural rate of 4%, a threshold that could set the economy into cost-push, demand-pull inflationary pressures.

Meanwhile, capacity utilization is standing at 74.9%, well below the full capacity level of 85%, which could trigger cost-push inflation at the wholesale level.

Still, some bottlenecks may be far worse than initially thought, kike in the labor market where jobs are begging to be filled even as unemployment rates remain elevated. And that forces some employers to hike wages, which eventually will translate into higher prices.

Meanwhile, inflation has begun to build into consumer expectations, as evidenced by recent surveys, including one by the University of Michigan, which showed that inflation is a significant concern for consumers.

The bottom line is that there's a fine line between transitory and persistent inflation. It can be easily crossed if market bottlenecks persist, preventing the economy's supply side from catching up with the demand side.

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This article first appeared on GuruFocus.

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