How much inflation can the country afford before we’re in trouble?
First, let’s get on the same page about some basics.
If you’ve noticed the price of a thing increasing over time (say, your favorite candy bar or the cost of college tuition), that’s inflation in action.
Economists use the broad increase (or decrease) in prices of goods and services across the country as a measure of economic health.
When inflation is stable and predictable, it’s a sign of a basically healthy, growing economy.
But, high inflation can quickly eat away at the purchasing power of your dollars, indicating that the economy might be overheated.
Deflation, or a decline in prices, can be a warning sign of a shrinking economy.
Recent data highlighted a surprise spike in inflation, indicating that prices increased faster than economists expected last month.1
Could this be a worrisome sign that the economy is overheated? Could $50 burgers be in our future?
On the other hand, could it be a temporary blip caused by the economy emerging from the pandemic-driven slowdown, complicated by supply chain issues?
Are the headlines catastrophizing?
They usually are.
Let’s look at the data.
The Consumer Price Index (CPI), one of the major indexes economists use to track inflation, showed a surprising spike in April, igniting fears of runaway inflation.
Core CPI (which excludes the highly volatile categories of energy and food) showed a 0.9% increase in April month-over-month and 3.0% year-over-year. That’s much higher than the expected 0.3% and 2.3%, respectively.1
However, digging a bit deeper, we see that just two categories of goods (used cars and transportation services) accounted for the vast majority of the surge.2
That suggests things like flights and train travel suddenly became more expensive after a year of rock-bottom prices.
Is that runaway inflation or the normalization of prices as the world reopens?
We can't tell from a single data point, but it's not unusual to see prices increase in sectors that experienced a severe slowdown last year.
And the jump in used car prices? Well, many folks are turning to the second-hand market right now, in part because new cars are caught up in global supply chain bottlenecks for things like semiconductors and raw materials.3
Inflation is something to keep an eye on, especially in a year when so many of the usual variables have been thrown into flux. An ongoing surge in prices could hurt our wallets as our dollars buy less over time.
However, a single monthly spike following a very weird period for the economy is not cause for alarm yet; we should prepare ourselves for more odd numbers coming out of different parts of the economy in the weeks and months to come.
Shortages of everything from ketchup to gasoline could lead to price increases and fluctuations as supply chains attempt to disentangle from pandemic disruptions.4
Should we expect markets to react to inflation (and other) headlines?
A negative market reaction is not surprising after weeks of strong performance. We should expect volatility ahead as we (and the economy) adjust to a post-pandemic world.
Bottom line: Expect the unexpected in 2021.
This past week featured a lot of churn and rotation between growth and value stocks, which made for a lackluster performance at the index level. The Nasdaq Composite (+0.3%) rose modestly, while the S&P 500 (-0.4%), Dow Jones Industrial Average (-0.5%), and Russell 2000 (-0.4%) ended with modest losses.
The market appeared to adhere to the "peak growth" narrative this week after April housing starts, April existing home sales, and the Philadelphia Fed Index for May all decelerated on a month-over-basis basis. To be fair, preliminary data out of the IHS did show manufacturing and service-sector activity accelerate in May.
What's more, the heavy selling in the cryptocurrency market this week likely served as a reminder that it might be a good idea to take some profits for stocks that are up big this year.
Accordingly, the cyclical S&P 500 energy (-2.8%), industrials (-1.7%), financials (-0.9%), materials (-1.4%), and consumer discretionary (-1.2%) sectors declined the most this week. Aside from the consumer discretionary sector, each of these sectors are up double-digit percentages this year.
Conversely, investors leaned defensively on the health care (+0.7%), real estate (+0.9%), utilities (+0.3%), consumer staples (+0.1%), and information technology (+0.1%) sectors. Granted, the outperformance of the tech sector was more likely a function of investors nibbling into beaten-down growth stocks.
The growth stocks helped the S&P 500 climb back above its 50-day moving average (4091) after it briefly dipped below the key technical level for the first time since March on Wednesday.
Separately, the FOMC Minutes from the April meeting revealed that some participants thought it might be appropriate to start talking about tapering asset purchases in future meetings if the economy continues to make rapid progress towards the Fed's goals on employment and inflation.
The market didn't react too noticeably to this passage, arguably due to a view that it might have been more surprising to see no mention of the need to start talking about tapering asset purchases.
The 10-yr yield decreased one basis point to 1.63%, representing a view that the Treasury market isn't that concerned about inflation and is siding with the Fed's view that inflation will be transitory.