Analysis: How persistent might inflation be?

One of the most notable economic developments of the past year, and one that directly impacts most Americans, is the resurgence of inflation. The trend represents a major departure from what had been a consistent pattern of low inflation over most of the past four decades.

In 2021, the cost-of-living, as measured by the Consumer Price Index (CPI), rose 7.0% for the year.¹ It was the highest calendar-year reading since 1981 and stood in sharp contrast to the trend over the past 40 years, when inflation averaged 2% to 3% annually. By contrast, as recently as February 2021, the inflation rate for the previous 12-month period was just 1.7%.

This high inflation environment has generated several questions, including:

• Is inflation back as a long-term consideration or is this just a temporary blip?
• What is the potential impact to you as a consumer?
• What does higher inflation mean for your personal portfolio?

Why inflation matters

Inflation represents the amount of increase in the cost-of-living over a given time period. It’s a measure of how much purchasing power is lost due to rising prices. CPI is the commonly cited statistic used to illustrate inflation on a broad level. CPI provides a measure of prices of goods and services that meet the primary needs of consumers, including items related to food, transportation, housing and medical care. CPI is updated monthly by the U.S. Bureau of Labor Statistics. The Personal Consumption Expenditure Price index, or PCE, is another important inflation gauge, and is considered the U.S. Federal Reserve’s (colloquially called the ‘Fed’) preferred inflation measure. The Federal Reserve is the country’s central bank and mandated by Congress to promote full employment, stable prices and moderate long term interest rates, so watching inflation is essential to their function.

What’s behind inflation’s return

One reason inflation turned into a headline issue in 2021 was the emergence of a more significant imbalance between supply and demand across specific segments of the economy. In recent months, this imbalance affected items such as lumber (reflecting significant new construction and remodeling), airfares, lodging, energy costs and used car prices. “In this unusual economic environment, people are spending more on specific items, driving up demand,” says Hainlin.

But it can be a challenge keeping pace with demand when supply chains are disrupted. For example, a shortage of semiconductor chips, now a key component in the production of motor vehicles, has led to a drop in inventory at automobile dealerships. Backups in unloading container ships and moving freight across the country have also contributed to supply chain disruptions.

The pandemic may be another factor contributing to today’s elevated inflation rate, according to Eric Freedman, chief investment officer at U.S. Bank Wealth Management. “Individual countries are managing the response to COVID-19 in different ways. Nations lack consistency in their COVID protocols, contributing to the persistence of inflation,” says Freedman. In other words, if a country forces business activity to slow or shut down as a precautionary measure, it may contribute to the supply chain disruption that has marked the recent inflationary surge.

How long will higher inflation persist?

One of the biggest questions is whether the current uptick in inflation is transitory in nature, as the Fed initially projected, or if it will remain an issue. “We still see inflation moderating over time,” says Rob Haworth, senior investment strategy director at U.S. Bank, “but it could be persistent simply because higher demand does not appear to be going away in the near term.” Haworth anticipates that over the course of the year, increased capital expenditures by businesses should offset the rising demand and help alleviate some of the cost pressures that drove inflation higher in 2021.

A dramatic change in monetary policy initiated by the Fed in late 2021 could be another factor. The central bank announced that it would curtail its “quantitative easing” program in the early months of 2022. Under that program, the Fed was purchasing $120 billion in U.S. Treasury and mortgage-backed bonds each month to help add liquidity to the market and boost the economy. The Fed also maintained a zero-interest rate policy on its fed funds target rate since early 2020. It appears poised to begin raising the fed funds rate several times in 2022.

Freedman says that for the Fed to succeed in tamping down inflation, it may result in a slower pace of economic growth. “The Fed will likely approach raising interest rates intelligently, but in this environment, the risks of a policy mistake by the Fed that generate unintended consequences are more visible.” The Fed retains a policy of maintaining an inflation rate in the 2% range over the long term. Whether it will have to take additional steps (such as raising the fed funds rate more quickly) to cool down the economy as a way of moderating inflation growth remains to be seen.

Two key areas to watch – energy and wages

For the 12-month period ending December 2021, energy costs had the biggest impact on the inflation rate, jumping 29.3%.² Freedman suggests that this indicates the Organization of Petroleum Exporting Countries (OPEC) continues to have significant influence on the oil market. “OPEC is not producing up to levels some expected to see, and the U.S. has not brought enough capacity online to add to supply in a meaningful way.” With reduced supply an ongoing reality, Freedman believes there is still a risk that oil prices could continue to rise, even though the price of crude oil reached its highest level since 2014 in the fall of 2021.³

The job market is another area facing its own supply-demand disruptions. While millions remain out of work, the Bureau of Labor Statistics reports there are 10.6 million job openings.⁴ In addition, a number of people have stepped away from the work force. The question is whether that’s a temporary trend or if it could turn into a sustained issue. “COVID-19 remains a concern for people,” says Freedman. “Some of the data we look at suggest that COVID is a primary reason why those at working age who are not seeking employment remain out of the workforce.” He believes labor trends in the first months of 2022 will better define whether labor shortages will force more significant wage growth. If that occurs, it could contribute to an extended period of higher inflation.

Tom Hainlin, national investment strategist for U.S. Bank Wealth Management, notes that investors will be attuned to what corporate earnings reports signal about the impact of the recent inflation surge. “If higher costs take a toll on profits, that could be a more tangible sign of broader concerns about inflation’s impact,” says Hainlin. To this point, corporate earnings have held up reasonably well despite concerns about rising costs for materials and labor.

How to manage inflation in your financial life

What does the altered inflation landscape mean for your own investments and broader financial plan? The answer likely depends on many factors specific to your circumstances, but it’s important to note that investment markets did not demonstrate significant concern over the inflation surge in 2021. Major stock indices lingered near record highs for much of last year. Bond yields (which move in the opposite direction of prices), are still considered low by historic standards. The benchmark 10-year Treasury note remains below the 2% mark.

“The market indicates that inflation will be in the 2.8 percent annualized range over the next three years and lower than that when you look farther out,” according to Freedman. “Investors are saying they don’t believe that inflation at current levels is sustainable.”

It may be beneficial to consider whether any adjustments are needed to your portfolio. Freedman notes that U.S. Bank continues to support the view that equities are well positioned in an environment of solid corporate earnings and low interest rates. Generally, a long-term, buy-and-hold strategy tends to work to the benefit of most investors. That should preclude any dramatic changes in your asset mix to respond to the inflationary environment. However, we do suggest investors assess their bond portfolios and emphasize diversification in what could be a rising interest rate environment; historically, bond portfolios have been sensitive to periods of Federal Reserve target rate increases, and this time could be similar.

Take time to assess how inflation might impact other aspects of your financial plan. For example, if you have variable interest rate loans, consider locking in a long-term fixed rate on the loan. This may help you avoid future interest rate increases, which could result from the current inflationary environment and shifting Federal Reserve policies.

Be sure to talk to your financial professional about what steps may be most appropriate for your circumstances.