In reality each inflationary spike was transitory
There’s a big difference between inflation that is only transitory in rate of change times, and inflation that is truly transitory in aboslute terms.
Inflation that is truly transitory in absolute terms would mean that a lot of prices go up due to a temporary supply shock of some sort, and then come back down when the supply shock is over.
Many types of inflation occur rapidly and then suddenly cool off. Indeed, here’s a model of what price inflation might look like this year:
On the other hand, inflation that is only transitory in rate of change terms would mean that a broad set of prices jump quickly and then stop going up quickly, but never actually come back down. Instead, they go through a permanent step-wise increase in price levels and reach a new equilibrium at a higher level.
This first chart here shows the year-over-year consumer price index change (aka price inflation) in the 1940s. Indeed, each inflationary spike was transitory. However, the second chart shows the absolute level of the consumer price index. After each inflationary spike, prices remained at that permanently higher plateau. In other words, inflation was transitory in rate of change terms, but not absolute terms.
Chart Source: St. Louis Fed
The current inflationary spike that we’re seeing in 2021 is being dismissed as being caused by supply shocks. But of course, all inflationary events involve supply shocks. That’s one of the inherent catalysts of why inflation happens, every time.
The 1940s had all sorts of war-related commodity and labor shortages. The 1970s had the oil embargo. The 2020s have semiconductor shortages, various commodity shortages, and shipping constraints.
On the other hand, rapid increases in the broad money supply that boost demand for goods and services without boosting the supply of goods and services, result in supply shocks and cause price inflation. As the market adjusts over time, this price inflation becomes transitory in rate of change terms, but with prices that ultimately settle at a higher level, due to more money permanently being in the system. This second type of inflation is likely what we’re experiencing at this time.
Some specific parabolic price levels will almost certainly come back down pretty far. Lumber’s extreme price behavior, for example, is due to an acute sawmill bottleneck.
However, many prices are unlikely to revert back to where they were pre-2021. Many companies including Procter and Gamble (PG) and Coca Cola (KO) are raising prices due to higher input costs. Many commodities such as copper are unlikely to fully retrace their 2020/2021 gains. Chipotle (CMG) is unlikely to reverse the shift towards $15 average wages once it implements them. These are higher equilibrium levels, with a lot more money in the system.
And as Warren Buffett said at Berkshire Hathaway’s (BRK.B) annual shareholder meeting in early May:
We are seeing very substantial inflation. We are raising prices. People are raising prices to us and it’s being accepted.
The Fed mostly has to keep rates low regardless of what inflation does, dismissing it as transitory and supply-chain related, but they could have periods of time where they briefly try to tighten and slow things down, before reverting course and turning dovish again when something breaks.
So, we need to stay on our toes, monitor economic indicators in rate of change terms, and focus on quality-businesses at good valuations.
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June 1, 2021 at 03:04PM