Mitch's Mailbox

May 18th, 2023

Is Inflation Becoming Entrenched in the Economy?

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Travis N. from Ventura. CA asks: Hello Mitch, having inflation back around 2% seems like it’s the key for markets and the economy to move forward. Do you have any concerns that inflation is becoming entrenched, either because of a wage-price spiral or because consumers have simply come to expect rising prices?

Mitch’s Response:

Before I dive into your question, I think it’s important to rewind the clock a bit on the root causes of inflation, and where those stand today. Looking back, we know surging inflation in 2021 was a byproduct of supply chain disruptions from the pandemic, a burst of a fiscal stimulus directly transferred to households, a shift in spending from services to goods, the Russian invasion of Ukraine (and its effect on commodity markets), and labor shortages.1

Most of these inflation forces have faded today.

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Supply chains are running relatively smoothly again, gas prices have fallen back to pre-war levels, and the labor force participation rate has climbed back up to its pre-pandemic trend. Consumers largely spent through fiscal stimulus long ago.

That leaves the two factors you bring up in your question. We know that wages grew 4% to 5% through the first four months of 2023, which of course is not consistent with the Fed’s 2% target. And in Q1 earnings reports, we saw many companies reporting few issues preserving profit margins, which means companies weren’t meeting much resistance from consumers encountering higher prices.

It follows that rising wages – coupled with consumer expectations for higher inflation – are not positives for the inflation outlook. These two things are often intertwined. If consumers assume prices are going up, they likely also assume their wages will be going up, too. This link needs to be broken, in my view, for inflation to settle at a much lower rate. 

It may be telling that consumers are becoming less worried about inflation. In a Gallup poll taken last fall, 20% of Americans called inflation the country’s biggest problem, and the issue dominated the midterm elections. In the most recent survey, however, just 9% of Americans thought it was the biggest issue. That could mean one of two things. Either inflation is truly becoming a lower risk, or Americans have simply come to live with it, which would imply some level of entrenchment as you mention in your question. We may not get our answer until later this year.

In my view, the inflation risk is indeed tracking lower. As I’ve written in other columns, the shelter component – which makes up a full third of the consumer price index – has been a key source of keeping inflation readings elevated. Shelter prices measure what renters and homeowners are paying for new and existing leases, which means recent declines in rents will not show up immediately in the CPI number. Given that median rents in the U.S. have been falling for the last several months, we would expect the shelter component of CPI to contribute significantly less by this summer and fall. There have also been growing signs of slack in the labor markets, which I think will gradually reduce wage pressures just as inflation falls back down to more acceptable levels.

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Disclosure

1 Wall Street Journal. May 10, 2023. https://www.wsj.com/articles/we-may-be-getting-used-to-high-inflation-and-thats-bad-news-d3a63e6f?mod=economy_lead_story

2 Zacks Investment Management reserves the right to amend the terms or rescind the free 4 Ways to Protect Your Retirement from Rising Inflation offer at any time and for any reason at its discretion.

3 Zacks Investment Management reserves the right to amend the terms or rescind the free 4 Ways to Protect Your Retirement from Rising Inflation offer at any time and for any reason at its discretion.

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