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  • Cameron Bunge

Should the United States be Worried About Post-COVID Inflation?

In light of the economic reopening and stimulus bills passed in order to mitigate the economic impact of the coronavirus, the United States is experiencing inflation at levels not seen in over a decade. High inflation is perhaps the most dangerous macroeconomic phenomena in any economy. Is this where the United States is headed?

For the first time in over a decade, the United States and other high income countries are experiencing signs of inflation in excess of the desired level. The US economy is expected to operate above full potential for 2021. This inflation can be seen most clearly in agricultural commodities such as corn, soybeans and wheat, all of which are trading at multi-year highs, and raw materials—most notably lumber, which has quadrupled in price since the beginning of 2020. These factors culminated in an April CPI increase of 4.2% compared to 2020 levels, the sharpest increase since the 2008 Financial Crisis. This increase came as a surprise to most economists who predicted a month-to-month increase of 0.2% in CPI, when in reality it was 0.8%.

Due to the unique circumstances of economic reopening surrounding the end of the COVID-19 pandemic, some of the macroeconomic measures that are commonly used to gauge inflation, such as CPI, are more difficult to interpret. This unpredictability is largely explained by poorly understood reopening effects on both the supply and demand side of the economy.

Post-pandemic demand has skyrocketed as businesses reopen and American consumers have more disposable income due to the stimulus bills passed by Congress over the past year. Despite the demand increases and supply shutdowns caused by the unique challenges of reopening, the economy has still grown through the first half of 2021. The economic effects of the stimulus spending are likely to continue in light of the Biden administration's proposed $6 trillion budget proposal which represents a significant increase in government expenditure in the US economy.Aside from stimulating economic activity directly, the growing federal deficit signals a disconnect between the United States consumption and domestic economy activity, a move that risks stoking inflation even further and makes it more difficult to predict.

In addition to responding to increases in real economic activity, inflation is often influenced by consumer confidence which can be far more reactionary. In times of uncertainty this can result in drastic swings, in excess of the changes predicted by the economic data . When consumers expect inflation to occur, they are more willing to accept price increases instead of decreasing their demand which perpetuates further price increases and weakens the purchasing power of the dollar.

Historically, the biggest determinant of the public’s inflation expectations are gas prices, which have seen sharp increases especially in the past month. Some of the short-term increases can be accounted for by the cyberattack which shut down the biggest pipeline in the US for several days. The last period of uncontrolled inflation in high income countries was due to oil supply shock in the 1970’s and the fear is that the US could return to such an environment of uncontrolled inflation in the post-COVID world.

While the United States is certainly experiencing in excess of what has been seen over the past decade or more, overall it is not a cause for significant concern. The Federal Reserve Board has set a target of 2% inflation over the past several years, a metric which it has slightly underachieved. As a result, the current inflation levels which have averaged approximately 2.8% through the first five months of 2021 will help bring long term inflation closer to this stated goal.

Barclays has predicted that we will likely experience peak inflation in May before leveling out for the second half of the year. The FRB currently has the breakeven inflation rate set at 2.44%. This metric represents what market participants expect the inflation to be over the next ten years, meaning that only a modest increase in long term inflation is expected. However slight, this increase in the inflation rate will likely see interest rates go up, which in turn would increase the cost of borrowing and cause investors to favor bonds more heavily.

Despite an environment of low unemployment and interest rates that has persisted through recent years and several rounds of quantitative easing, inflation has failed to substantially increase. In today’s highly globalized markets, domestic economic metrics are no longer sufficient predictors of inflation when one considers the significant disinflationary influence of China in the world market. But with recent rises in Chinese domestic inflation and a shrinking, although a still massive labor force, these disinflationary forces are expected to weaken in the coming years.

Significant increases in government spending are likely to occur during Biden’s administration. This combined with the political difficulty of raising the tax rate and the expansionary monetary policies that have been unleashed in the aftermath of the 2008 Financial Crisis and COVID-19 the possibility of inflationary overheating has substantially increased. Given that unexpected inflation is more dangerous than general inflation, this does create a potentially volatile situation for the future, especially when combined with a systematic weakening in disinflationary forces that has occurred over the past decade as economic stimulus became more important than moderating inflation.

These factors will compound to make investing an overall risker and less predictable activity over the coming years, as well as push US Treasury yields even lower, which have been falling for the past forty years— even if American consumers do not feel the direct impacts of substantial inflation.

Although signs do not indicate at this time that the United States will experience uncomfortably high inflation in the foreseeable future, I would advise consumers and investors to exercise heightened caution in the face of increasing volatility. Additionally, we may experience a flight to quality as investors come to prefer the relative safety offered by bonds, although in context of their deteriorating returns investors may be better served by adopting a saddle strategy, strangle strategy or investing in volatility indexes to profit off of the likely volatility in the market.



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