This chart shows the year-over-year change in the Consumer Price Index (CPI), which rose 0.8% for February 2022, or 7.9% year over year. Core prices, which exclude the more volatile elements of food and energy, rose a more modest 0.5% from January, or 6.4% year over year. Both figures are now higher than at any point in the past 40 years. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.
Inflation proved stubbornly high in February. The Consumer Price Index (CPI) rose 0.8% for the month, or 7.9% year over year. Core prices, which exclude the more volatile elements of food and energy, rose a more modest 0.5% from January, or 6.4% year over year. Both figures are now higher than at any point in the past 40 years.
As tempting as it is to blame this surge on the war in Ukraine and subsequent fears of disrupted food and energy supplies, recent history refutes this simple explanation. Inflation started rising well before the onset of hostilities in eastern Europe, and energy and food only account for a small portion of the rise. The real source of higher prices is the perilous combination of excess household savings, pent-up demand and supply chain disruptions. We continue to believe that all of these cyclical drivers will ebb over the course of 2022 and that inflation in the latter half of the year will trend lower.
Much of the emergency fiscal measures enacted by the Trump and Biden administrations were designed to put money into people’s pockets, in recognition of the fact that household spending is the primary driver of economic activity. It worked. In January 2021, household savings stood at an annualized level of $4.3 trillion, having soared as high as $7.0 trillion in early 2020. As of January 2022, savings had retreated to a more normal annualized level of $1.7 trillion. The good news is that all of this implied spending propelled the economy out of recession and into expansion in record time. The bad news is that this same dynamic drove prices higher across the board. At the same time, this good news and bad news is increasingly old news: Household savings is back down to pre-pandemic levels, implying that pent-up demand has largely been met, and excess savings and spending should soon cease to be a source of inflationary pressure.
This chart shows disposable income and personal spending from 2006 to 2022. As of January 2022, household savings had retreated to a more normal annualized level of $1.7 trillion. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.
Supply chain problems exacerbated the pricing pressures of consumer demand. Much of this disruption originates in a tight labor market: There simply aren’t enough workers to unload container ships, drive trucks and manage warehouses. This, too, is beginning to improve, albeit slowly. Almost 1.7 million people entered the labor force in January and February, and global freight rates have declined sharply from last fall.
Although the war in Ukraine did not cause the surge in inflation over the past year, it threatens to prolong it. Just as we learned in the early days of the pandemic how reliant the global economy was on a finely tuned and finely timed supply of goods and services, the Ukrainian and Russian economic catastrophes could prolong the inflationary pressure of disrupted supply for certain goods. In addition, oil prices have moved predictably higher on the prospect of Russia’s exit from the global energy markets, imposing even more upward pressure on prices.
We conclude, however, that energy prices pose less of an inflation threat than common wisdom might imply. First, we’ve been here before: From 2011 to 2014, oil prices hovered between $80 and $100 per barrel, while the U.S. economy continued to expand, and inflation averaged less than 2%. Second, as the U.S. economy has evolved away from a reliance on industry and manufacturing, and toward more exposure to information, technology and services, we consume less oil. In 1990, the U.S. economy consumed 1,062 barrels of oil for each $1 million of GDP. By the end of 2021, it only took 307 barrels of oil to produce the same amount of GDP, adjusted for inflation. This represents a 71% decline in economic reliance on oil and argues that higher oil prices don’t pose the same inflationary and economic threat that they did a decade or two ago.
This chart shows U.S. energy reliance from 1990 through 2021. In 1990, the U.S. economy consumed 1,062 barrels of oil for each $1 million of GDP. By the end of 2021, it only took 307 barrels of oil to produce the same amount of GDP, adjusted for inflation. This represents a 71% decline in economic reliance on oil. If you are in need of the data found in this graph, please contact BBHPrivateBanking@bbh.com.
Finally, as 2022 unfolds, the year-over-year inflation comparisons will become easier. Note in the previous bar graph that a year ago inflation was a mere 1.7%. Life was very different in February 2021: Vaccinations were just rolling out, many schools remained remote or hybrid, travel was a rare treat, and unemployment was over 6%. There was very little pricing pressure. Fast-forward a year, and the world looks much different (and better) now. The year-over-year comparisons are therefore now rather stark but will become more comparable by the time we get to late spring. This is admittedly an optical improvement, but as the base effect ages, we should find that headline inflation rates improve.
Despite this optimistic expectation, we are not complacent on the issue of inflation. Indeed, even modest inflation poses a serious risk to the objective of protecting and growing capital over time. This informs the way we approach asset allocation as well as security selection. Equities provide the best protection against inflation over time, despite the occasional bout of price volatility. Furthermore, seeking out those companies that have greater-than-average pricing power can add even more inflation protection into an investor’s portfolio.
Opinions and forecasts represent the author’s views as of the date of this commentary and are subject to change without notice. Past performance does not guarantee future results.
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