Transitory US Inflation?

​​The annual inflation rate in the US soared to 4.2% in April 2021 from 2.6% in March, which was significantly above market forecasts of 3.6%. Indeed, it is the highest reading since September 2008. We don't have to look too hard or far to see why this is happening. We have been in a reflationary environment with a tsunami of demand as the economy reopens.

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​The annual inflation rate in the US soared to 4.2% in April 2021 from 2.6% in March, which was significantly above market forecasts of 3.6%. Indeed, it is the highest reading since September 2008. We don't have to look too hard or far to see why this is happening. We have been in a reflationary environment with a tsunami of demand as the economy reopens. We've got soaring commodity prices with grains and energy markets heading north at a rate of knots. We've seen supply chain issues and shortages in the semiconductor market. We've also got the base effect as the April inflation numbers come a year after the pandemic lockdown when the economy was in dire straights.

The Base Effect

If we look at this just from the perspective of the base effect, you could say this is transitory inflation. The rationale being that, we move forward, away from the April 2020  measuring point, which is now known as "The Great Lockdown" and resulted in the worst economic downturn sine the Great Depression, we could see inflation cooling a little bit. However, as mentioned, this is only one factor in the melting pot. We've got other inflationary pressures creeping in to the mix.

​Supply and Demand

On the supply side, businesses are dealing with increasing cost for raw materials and fuel. Look at the price of copper and lumber in the construction business as well as the uptrend in crude oil and refined products. On the demand side, we've got consumers with more cach in their pockets from stimulus cheques and more savings. As the lockdowns ended, people wanted to spend some of that money. 

Tighter supply and increased demand equals higher prices. So the inflation numbers we are seeing may not be as transitory as the Fed would have us beleive!

Wages Increases

In addition, there is the impact of wage increases. Inflation expectations have been well anchored in recent years but comsumer inflation expectations are picking up so we could see more upside pressure on wage increases. In an environment of higher inflation, employees expect the wages to increase in line with inflation and to offset the effects of this in their own cost of living.

Companies are also under pressure to increase wages to attract new employees. The jobs reports show that getting people back into jobs in proving more challenging than expected. There are several reasons for this. Some people dpon't want to go abck to work as pandemic fears remain. Others have been constrained by working from home and home schooling. Some people don't find the wages on offer attractive enough to return to the workforce becuase of extended and uprated unemployment benefits. Other may take earlier retirement. 

Inventories and Backlogs

The Institute of Supply Management (ISM) reports are showing a backlog of orders at all time highs and inventories are at an all time low. Companies can't keep pace with demand. Look at the situation they are in with increasing costs for raw materials, delays in the supply chain, pressure to increase wages to attract new employees and demand for higher wages from exiting staff to match  current inflation levels., it is highly likely that inflation will be around for a while longer and potentially into the end of this year.

Conclusion

The Fed's purchases add up to $120 billion a month and have been saying that interest rates wll remain at current levels until 2024. However, if the economy keeps steaming ahead at it's current pace, with inflation running hot, then there is an increasing probability of the Fed bringing this forward.

So traders and investors are assessing what the Fed will do next. Will they be forced to change their story and signal to the market that they will start tapering their bond purchases sooner than they thought, ahead of the inevitable rate hikes? That is certainly one possible scenario and the probabilities for this outcome are increasing.