As consumers, we see inflation. We’re seeing it at the grocery store and most certainly at the gas tank. As market analysts, we see inflation. One year ago, Energy was the worst performing sector with oil was $25 a barrel. Today, Energy is leading the sectors, up nearly 40% year to date, and oil is $65 a barrel. It is easy to see inflation when compared to year-ago lows. Still, our economy hasn’t seen double-digit inflation since the early 80s, which means 50-year-old investors were 10-12 years old—yes, they lived through it but never really experienced it.
Every recession is different. Compared to the 2008–2009 recession, our current economic conditions brought on by the pandemic are very different. Understandably the fear is that this time, the large amounts of money being injected into the system whether via stimulus checks or bond purchases, will lead to inflation. But the Federal Reserve has said that what we are seeing is transitory inflation—something that won’t be persistent with price increases temporary in nature and a direct effect of suppressed commodity prices early in the pandemic now creating a base effect.
In 2008–2009, the Fed was aggressive with quantitative easing and increased the monetary base, which is the feeder for the money supply. However, banks held on to the money—and were incentivized to do so thanks to the Fed paying interest on bank’s excess reserves. This time, we essentially have “forced lending” in the form of PPP loans and direct stimulus to the consumer. Couple that with the supply chain shock, and that creates the risk of inflation a little more now than we’ve seen in recent years.
Disruptions to the supply chain began in China in February 2020. As the global economy shut down for the pandemic, the vulnerabilities in the supply chain were exposed with shortages of pharmaceuticals, medical supplies, and household products. The supply chain generally involves raw materials, contract manufacturers, specialist subcontractors, third-party testing facilities, inventory warehouses, and freighting companies. A lack of workers can slow down any one of these steps causing delays. Part of the supply chain issue is the lack of an available and qualified workforce.
One of the other key factors we’re watching is the velocity of money, which is the frequency at which currency is used to purchase goods and services. For the first quarter of 2021, the St. Louis Fed measured the velocity of money around 1.198. While not a key economic indicator, it can be used to help understand conditions in gross domestic product, unemployment, and inflation. It’s also correlated with business cycles; therefore, the velocity of money will generally rise with inflation. The Fed has flushed the system with money through business loans and direct stimulus, but it is not churning, which supports the Fed’s belief that rampant inflation is not on the horizon. Instead of spending this newly found money on goods and services, consumers are saving it or investing it in financial assets.
During the 2008–2009 recession, the Fed encouraged investors to move to the stock market by keeping interest rates low, which forced investors out the risk curve to achieve their desired rates of return. Today, we do not need this encouragement as everyone seems willing to take on the risks that come with stocks. With the free money consumers are receiving they’re willing to buy anything and everything. Nearly everyone is making money no matter what they’re investing in, which is pushing valuations to the second-highest level in history. Furthermore, investors are jumping into the most speculative investments, such as cryptocurrencies, non-fungible tokens (NFTs) and special purpose acquisition companies (SPACs).
Still, overall economic data looks strong right now—aside from the employment situation. We have roughly 8 million less employed than we did before the pandemic, but we also have more job openings than before the pandemic.
Is the inflation we’re seeing transitory? We won’t know until much later after it has passed or when we are fighting rapidly rising inflation. Until then, it is also impossible to predict what the Fed will do to combat it. Regardless, returning to normalcy will allow us to better weather the next recession.
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