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Inflation: A Supply Phenomenon

Constrained Supply. The global economy is reopening, with the U.S. leading the way with its vaccine roll-out. While the Delta variant of COVID-19 gives pause, vaccination rates, prior exposure, and focused mediation methods will limit the impact. The challenge for financial markets is that unprecedented monetary and fiscal stimulus delivered high valuations in most asset classes, while supply demand imbalance delivers higher inflation. The latter is temporary, while the former more enduring. The catalyst for a valuation reversal is uncertain and fighting the momentum from the wave of monetary stimulus takes unparalleled resolve. As long as credit remains accessible and innovative technologies deliver compelling narratives, investors face the same burden: exiting before the momentum reverses. In this environment, timing is everything. Now is the moment for active investing to add value.


Price increases as supply and demand rebalance are temporary distortions of a rebooting economy. Valuations across all asset classes are the greater risk.

Photo: Andy Li on Unsplash


Data Artifacts. The collapse of the global economy in 2020 from the Pandemic was unprecedented in its speed and depth. Demand dried up overnight as quarantines spread across the globe and supply left without a partner. Prices thus dropped and continued through May as the economy remained shuttered. This result is a hallmark of supply-demand analysis in every economist class and was not a surprise. The surprise was that prices did not fall further.


The annual change in consumer prices only slowed to a 0.2 percent increase in March 2020 (Exhibit 1). It is extraordinary that price levels did not decline on an annual basis in a world without demand. Prices are now accelerating as renewed demand meets constrained supply, with the yearly change jumping to 4.9 percent. Businesses of all stripes voice their concerns of inflation gone wild. The reality is a much tamer beast.


Both results are a function of the composition of consumer prices and the unbendable structure of the underlying data. These data artifacts enable a clearer understanding of future price levels. Critically, persistent price increases require a persistent supply-demand imbalance, which does not appear the case.


Exhibit 1. U.S. Consumer Price Inflation Year/Year Change (%)

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations.


Variable Prices. Consumer price levels have three major categories: commodities, services, and shelter. Each has different market dynamics, price discovery processes, and varying price volatility (Exhibit 2). Over the last forty years, the prices of services and shelter are stable while commodity prices meander significantly. These data points are a function of the degree of market competitiveness. The freer the market, the more likely prices will vary as supply and demand conspire to set prices.


Commodities are widely traded in financial markets and supported with robust futures and options markets as a further avenue for price discovery. In contrast, the market for services is opaque, illiquid, and has a supply-demand imbalance (many workers, few employers). Service prices are lower because employers enjoy buyer power. Housing is a similar market that enjoys illiquidity, infrequent trading, complex pricing, and high transaction costs. Thus, the volatile commodity component drives fluctuations in the general level of consumer prices. This insight is critical to understanding future inflation pressure.

Exhibit 2. U.S. Consumer Price Index Major Components Year/Year Change (%)

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations.


A Matter of Composition. While the volatility of the components is a material contributor to overall price levels, weights also matter. Since the 1950s, commodities weights declined from over 60 percent of the basket to less than 40 percent today (Exhibit 3). The overall price level fluctuations no longer reflect the volatile commodity component, but the more benign service and shelter components. In the last four decades, the only material volatility in services and shelter was during the Great Recession of 2008, when a housing market collapse drove an employment collapse. This lower price volatility is primarily a function of the changing weights in the consumer basket.

The weight of services has gained at the expense of commodities. From a supply-demand standpoint, the price weighting moved from a more competitive market (i.e., commodities) to a less competitive market (i.e., services). Since services are a buyer’s market (e.g., bargaining power resides with the employer because there are dramatically more employees than employers), the ability for employees to demand higher wages as their costs increase is lower. The result is reduced price volatility.


Exhibit 3. U.S. Consumer Price Index Major Component Weights 1959-2019

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations.


Buying Discretion. A consumer price index reflects what people purchase on average. While the basket is stable throughout the year, it can change materially during the year as market prices alter consumer behavior, particularly volatile commodities. A material aspect of this behavior change is the substitution effect. This behavior occurs when a consumer replaces a high price good (e.g., beef) with a lower priced good (e.g., chicken). The critical element is the consumer’s ability to exercise discretion to minimize the impact of higher-priced goods.

Buyers are sometimes price takers for goods or services and cannot substitute these items. Two of the leading price increases over the four decades come from this category, health care and tuition (Exhibit 4). In contrast, goods with significant import components (e.g., news cars and clothing) saw price increases below the headline level because buyers exercise choice in these markets. As housing and services increasingly dominate the consumer basket, the price impact of the commodities becomes less severe. The trouble with this outcome is that consumers have a higher non-discretionary basket, limiting their ability to adjust their buying habits. Thus, sustained changes in wages or housing costs are the critical drivers of future inflation.


Exhibit 4. U.S. Consumer Price Index Subcomponent Change (%, Annual) since 1982

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations. Selected subcomponents of U.S. Consumer Price Index All-Urban Consumers.


Servicing Housing. In the U.S., housing prices increase are everywhere. Constrained supply and heightened demand are a potent mix to create higher prices. The constrained supply is a function of fewer people moving during a pandemic. At the same time, demand has jumped as financing costs fall. The trouble? A lower finance cost with a higher price delivers an overall cost that is essentially unchanged, which housing costs and rent prices reflect (Exhibit 5). The reality is that the housing component of inflation is increasing at a four-decade low. The supply-demand balance risk is that lifting of moratoriums on evictions and foreclosures could cause a supply shock that lowers prices.


Exhibit 5. U.S. Consumer Price Index Subcomponent Change (%, Annual) since 1982

Source: U.S. Bureau of Labor Statistics, retrieved from FRED. CRM Calculations. Selected subcomponents of U.S. Consumer Price Index All-Urban Consumers.


For services, medical cost changes reached a peak during the initial stages of the Pandemic yet are now also near four-decade lows. As the Pandemic fades, demand and prices should also recede. While new car prices accelerated recently, they are a function of constrained supply that will reverse as manufacturing restarts. In total, these components account for 45% of the consumer price basket, and the future supply-demand plausibly suggests weaker prices. Inflation hawks have commodities as the driving factor, a component that the consumer’s choice can mitigate. Doves need not cry.



This article is the Macro View in our Global Portfolio Strategy for the second quarter of 2021. Read more here.


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