Will Today's Inflation be Temporary or Longer Term?

Our previous commentary discussed one of the big questions on investors’ minds; whether stock markets had become overvalued. Now we will look at the other big question for the economy and markets; is the recent pick-up in inflation the start of a new inflation cycle and period of rising interest rates, or is it just temporary?

To understand this question, it’s important to understand what inflation is. In its simplest form, inflation occurs when the amount of money trying to buy a particular good or service exceeds the supply of that good or service. While general inflation has been fairly subdued over the last number of years, there has been severe inflation in things like real estate or art prices and, more recently, used cars. In the case of real estate, we know prices have been fueled in large part by low interest rates enabling buyers to borrow larger amounts of money. With used cars, it’s because global supply shortages, particularly in microchips used in cars’ electronic systems, have put a dent in new car production, creating higher demand for used vehicles.

But, the big question is, will these pockets of inflation spread to the broader economy, particularly to food and wages? To get an insight to this, the high inflation of the 1970s and early 80s could provide a useful example. Back then, inflation ran at over 10%, prices were going up much faster than most incomes and it was very harmful to the economy (I remember when I had my first serious job after university in 1983, when inflation peaked at around 15% per annum, we were all asked by our boss to accept pay increases of only 7% to do our part to help tame inflation!). However, global governments ran large deficits for years and central banks kept interest rates below the rate of inflation for an extended time. That allowed inflation to take off. It also created an inflation mindset, that sent wage demands soaring. It wasn’t until central banks jacked interest rates up in the 1980s above the rate of inflation that they took away the punch bowl.

So, will we see something similar today? Our feeling is no. Governments have spent huge amounts of money to sustain the economy and citizens through the pandemic, but we think they will have to reign this spending in. We also expect current supply shortages to be alleviated once global production recovers as economies around the world re-open. Finally, this will probably keep wage pressures fairly subdued.

For investors, it means that interest rates should not rise substantially from today’s levels and they need not fear the negative impact of higher rates on stock markets. However, none of our above assumptions is guaranteed and we will continue to watch these important economic signals.