Will These 3 Trends Lead To Higher Inflation?

At first glance, the current inflation numbers are startling, with the Consumer Price Index rising 4.2 percent year-over-year in April. If we break down those numbers—taking out the effects of the pandemic and normalizing over a longer time period—we find that inflation is similar to where it was back in 2018 and 2019. No need to panic in the short term. But could we see higher inflation ahead? To answer that question, we need to take a closer look at the longer-term trends.

1) The Cost of Labor

One of the things we’re hearing a lot about is a labor shortage and consequent wage inflation. A core assumption in American business is that there is a virtually inexhaustible labor supply, at or close to minimum wage. In many markets, that assumption is being challenged, with many companies being forced to raise their pay well above the minimum. Arguably, this shift is due to COVID; many people are reluctant to return to work, which is artificially suppressing the available labor supply. This is the assumption that is driving many states to eliminate the supplemental federal unemployment payments that make it more lucrative to stay at home. That move will probably work, and in any event, the federal payments expire in September. But what if it doesn’t?

With large parts of the boomer generation unlikely to return to the workforce, with other formerly reliable labor sources such as immigration under attack, and with the millennials aging out of junior, lower-wage jobs, it is very possible that lower-wage jobs might have a much tougher time getting filled. The participation rates and employment cost indices will need to be watched closely through the rest of this year to see if this really is an emerging risk.

2) Supply Chain Snafus

Supply chain problems are another concern, for everything from simple commodities like iron to complex manufactured goods like electronic chips. Here, too, the core assumption has been that supplies of everything will be generally available, although the cost may vary. Just as with labor, that assumption is now not working, and shortages are driving costs—and inflation—up.

Here, the problem is probably shorter term than the labor question, as miners and manufacturers can drive up production in fairly short order, while producing a new worker takes at least 16 years due to child labor laws. And while that statement is a bit flip, it is also accurate. Commodity producers can scale up production in the short term and open new mines in the longer term. Manufacturers can add new shifts or assembly lines in the short term and build new factories in the longer term. These are solvable problems, in terms of the amount of production. But how quickly they can be solved is a real question. Again, this is something that will need to be watched through the rest of the year. How quickly can we normalize? And what effect is that having on the economy?

3) Deglobalization

While we could solve the production problem, cost is another issue. This is the real inflation threat going forward, and it is one that touches both of the above points. Even if the world economy remains integrated, China’s labor force is now shrinking, so there will be more labor constraints going forward. Labor costs may not be forced up, but they will not be declining either. And, if relations between the U.S. and China get worse, we could see companies forced to reshore operations here, which will worsen any labor shortages in the U.S. and certainly drive up relative costs.

The same holds for commodities and manufactured goods. A substantial portion of everything we consume is sourced and made abroad because it is cheaper and more efficient to do it there. If and when globalization starts to turn, costs will go up and efficiency will go down—and that could drive inflation here higher. This is likely to be a slow and multiyear trend, but there are signs it is already starting—a risk definitely worth watching.

The Big Picture

The current spike in inflation is likely to fade. But when we look at the bigger picture, we can see that the many tailwinds we have had over the past decade that kept inflation low are likely to reverse and that inflation over the next 10 years will very probably be higher than the past 10 years. That does not mean we are moving back to the 1970s, of course, much less to hyperinflation. It is something to watch.

For that reason, the current inflation spike—while due to pandemic effects—is a great opportunity to think through how the world is changing and what that means for your portfolio. Don’t panic about inflation. Do use this time to think through where you are now and where you want to be as things change. Because they are changing.