Analysis: How persistent might inflation be?

Key takeaways

• Inflation continues to dominate economic and market headlines in 2022.
• Getting inflation under control is the Federal Reserve’s primary focus now.
• Higher prices are likely to be a persistent reality for the time being, which may be a consideration for investors.

One of the most notable economic developments of recent times, and one that directly impacts most Americans, is the resurgence of persistent 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. So far in 2022, inflation increased further. Over the 12-month period ending in June, living costs as measured by CPI rose 9.1%, the largest inflation spike for a 12-month period since November 1981.² It declined modestly since then, but remains above the 8% level on an annualized basis and continues to represent a challenge for consumers and investors. Of specific concern is that “core” inflation (excluding the volatile food and energy sectors) rose more quickly in August than was the case in the previous month.³

This high inflation environment has generated several questions, including:

• How long will this environment persist?
• What is the potential impact to you as a consumer?
• What does higher inflation mean for your personal portfolio?

Why inflation matters

Inflation represents increases 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. Recent CPI data indicates that inflation remains a significant concern.

The U.S. Commerce Department’s Personal Consumption Expenditure price index, or PCE, is another important inflation gauge, and is considered the U.S. Federal Reserve’s preferred inflation measure. The Federal Reserve (Fed) 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.

The broad PCE figure rose 6.3% for the one-year period ending in July, a modest drop from its June reading of 6.8%, which was the highest reading in more than 40 years. The more narrow “core” PCE gauge (excluding the volatile food and energy categories) showed inflation at 4.6% for the 12 months ending in July. This remains high, but is below the peak of 5.3% it reached for the 12-month period ending in February.⁴ The Fed has made clear that the persistent nature of today’s elevated inflation environment requires that it continue to pursue an aggressive monetary policy response.

What’s behind inflation’s return

One reason inflation is a major concern is the growing imbalance between supply and demand across specific segments of the economy. This imbalance affected items such as lumber (reflecting significant new construction and remodeling), airfare, lodging, energy costs and car prices. “In this unusual economic environment, people have spent more on specific items, driving up demand,” says Tom Hainlin, national investment strategist at U.S. Bank Wealth Management.

Some of the difficulties arose due to supply chain disruptions. For example, a shortage of semiconductor chips, now a key component in the production of motor vehicles, led to a drop in inventory at automobile dealerships. The pandemic may be another factor contributing to the current 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. There’s a lack of consistency in 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. China is a recent example, as it shut down some major cities to contain a COVID outbreak. This contributed to production delays for some exported goods.

Russia’s invasion of Ukraine added another element of risk to the inflationary environment. Russia is a leading exporter of oil and natural gas and a major supplier for most European nations. Both Russia and Ukraine are major agricultural producers as well. Shipping interruptions on the Black Sea, which borders Ukraine to the south, delayed commodity deliveries. All of these issues exacerbate inflationary pressures throughout, although regular shipping of Ukraine’s agricultural products recently resumed.

How long will we live with higher inflation?

One of the biggest questions is how long current inflation trends will persist. “There are reasons to believe that inflation will stop moving higher,” says Rob Haworth, senior investment strategy director at U.S. Bank. “Commodity prices flattened out over the summer, which should mean inflation is peaking. That could be a signal that consumers stop expecting inflation to keep rising, which would be a positive development.” Notably, Haworth acknowledges that the Fed won’t be able to achieve its stated target annual CPI range of 2% in 2022. “Consensus projections now are for inflation to be more in the 5-6% range by year’s end, which is still lower than where it stands today,” says Haworth.

The Federal Reserve’s monetary tightening strategy is clearly aimed at reining in the surge in inflation. The central bank has ended its “quantitative easing” program. Under that program, the Fed purchased $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. That policy changed in March 2022, when the Fed began to raise the fed funds rate. Fed Chairman Jerome Powell has stated that “inflation is much too high.”⁵ Haworth says “while the Fed wants to avoid driving the economy into a recession, its attention is fixed on addressing the inflation situation before it gets out of hand.” Interest rate hikes and reducing its asset holdings are two strategies the Fed has indicated it will continue to pursue throughout the year to fight inflation.

Key areas to watch – energy, food and wages

For the 12-month period ending August 2022, energy costs were a major contributor to the elevated inflation rate, jumping 23.8%, though energy prices moderated in recent months.³ Freedman points out that 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.” Nevertheless, oil prices stabilized in mid-summer, dropping from a peak of $124/barrel in March to under $90/barrel by the end of August. That is still significantly higher than where oil prices began the year, at about $75/barrel.⁶

“If higher costs take a toll on business profits, that could be a more tangible sign of broader concerns about inflation’s impact,” says Tom Hainlin, senior investment strategy director at U.S. Bank.

Like energy costs, food prices are another “non-discretionary” expense for households, and trends there raise more concerns. In the 12 months ending in August 2022, food prices within CPI grew by more than 11%.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 nearly 11.2 million job openings.⁷ In addition, a number of people have stepped away from the work force. Freedman believes labor trends in 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.

Hainlin 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 business profits, that could be a more tangible sign of broader concerns about inflation’s impact,” says Hainlin. Recent profit reports have shown some signs of concern in select sectors of the economy, such as retail outlets.

How to manage inflation in your financial life

What does the altered inflation landscape mean for your own investments and broader financial plan? Inflation appears to be a factor contributing to 2022’s challenging investment environment. Stock markets experienced significant volatility and the S&P 500 fell into bear market territory in June (a drop of 20% from its peak). Stock markets rallied in July despite continued bad news on the inflation front, but retreated again since that time. For much of 2022, bond yields moved up significantly, reflecting the high inflation environment. By mid-June, the yield on the 10-year Treasury note was close to 3.5%, a major jump from the 1.5% yield it paid at the end of 2021. In subsequent weeks, the 10-year Treasury yield temporarily moderated, falling below 3.0%, but again moved above the 3.0% level in August.

Freedman notes that U.S. Bank Wealth Management has shifted its position from a “pro-growth” mentality to a more balanced outlook for the months ahead. “We’ve downgraded our view and have concerns about the impact of economic growth slowing.” Freedman believes that the Fed’s intention to move more quickly to raise interest rates combined with uncertainties in the energy market resulting from the conflict in Ukraine create potential risks that could lead to a “choppy” environment for capital markets. Stock markets are likely to remain volatile in the near term. Opportunities in the bond market are more attractive given that higher yields can be earned than was the case earlier in the year. Investors should remain cautious about the potential for further interest rate increases, as rising rates reduce the value of bonds already on the market.

It may be beneficial to consider whether any adjustments are needed to your portfolio. 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.

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.