Your complete guide to inflation outlook in 2021

Part 1

Inflation, you know, that thing your parents tell you existed in the 1980s but you haven’t experienced throughout your life. One cannot think about financial returns or consumer prices outside of the context of inflation – a 15% return sounds great, until you hear that inflation is 20%. Inflation is unarguably a significant risk to rising stock markets and the economy in 2021.

In the next couple of emails, my co-author Will Carpenter and I will systematically recap the inflationary trends in 2020 and outlook into 2021.

Inflation, explained, in a basket

Inflation is the phenomenon of rising price levels, which corresponds to decreasing purchasing power of a currency. Generally, inflation is caused by two economic phenomena: 1) demand-pull; 2) supply-push. When demand in an economy surges far beyond available supply, this can “pull” prices upward with too many dollars chasing too few items. On the other hand, if some event restricts supply of a good, this can “push” prices for that good upwards.

In the U.S., inflation has been measured primarily through Personal Consumption Expenditures (PCE) and the Consumer Price Index (CPI). The two measures have different methodologies but usually yield similar results, with CPI typically running slightly higher. For the past decade, PCE has been stubbornly low, often coming in below the Fed’s target of 2%.

Both indices are calculated based on the measurement of a basket of goods and services. So, if you want to make a projection about inflation, you have to look into the CPI basket and see what parts are going up. 40% of the CPI basket are housing related and 20% are healthcare, so a significant portion are services, and only 30% are made of goods.

That is why the trade war’s impacts have had relatively small weights on inflation (since goods prices going up doesn’t matter as much), and also why Covid-19 has arguably been more deflationary than inflationary when the services sector is hit very hard and will not be picking back up soon.

During the pandemic, apartment rents declined significantly, and because housing has a weight of 40% in the CPI basket, this is really pushing down the overall inflation. Another statistic that you might find shocking is that 40% of the increase in core inflation this August was due to a 4% gain in used car prices year-over-year.

What we’ve been observing during this pandemic is that prices went up for some goods (like used cars, Purell, paper towels), but there are no signs of broad-based inflation. If you are worried about inflation, you have to point to us where exactly it’s coming from.

Did Covid-19 cause inflation? Yes and no.

Many of you have asked whether Covid-19 is more of a deflationary or inflationary shock. Our punchline is: Covid has caused inflation in certain narrow asset classes, but there hasn’t been broad-based inflation.

Used car prices and home building supplies were two items that have seen marked surges in prices due to Covid-19. See the chart below where used car and lumber prices are both graphed since 2015:

*Source: Federal Reserve Economic Data (FRED)*

Both of these instances are most likely due to a combination of demand-pull and supply-push. Car inventories were scarce in the U.S. after most international importation of vehicles dried up in April. Homes have seen an uptick in demand most likely due to historically low mortgage rates around 3%, thanks to the Fed cutting short-term rates to near zero when the pandemic hit.

However, Covid as a whole, like other recessionary incidents, was largely deflationary. Quarantines and financial difficulties reduced consumer spending and aggregate demand. Below illustrates how core PCE had been mostly below 2% (red line) and showed a marked decline to around 0.92% in April. Since then, it has rebounded to around 1.40%.

Why hasn’t Fed’s money-printing caused hyperinflation?

You might wonder why we’re not seeing inflation even though the Fed has been “printing money” non-stop through its QE programs since 2008. The Fed has injected trillions of dollars worth of liquidity into the economy since March, but this money is mostly going into credit markets.

In monetary theory language – the Fed’s money printing has only created inflation in financial assets but not transactions in real GDP. Financial assets are inflated and equities are up, but the aggregate demand by the broader economy has not fundamentally gone up. Therefore, one could argue that Fed’s money-printing programs can only lift up asset prices but not consumer prices.

So, why should we care about inflation?

For the everyday consumer, it’s about having less purchasing power of money they use to buy goods and services. If inflation is growing quickly, many consumers might demand higher wages to mitigate the declining value of their earnings. Higher inflationary expectations also incentivize consumers to spend more in the present if they believe their money will be worth less moving into the future. This effect is sometimes useful in times when economic growth is desirable (like right now), and the Fed often tries to boost expectations to spur growth in consumer spending.

For the investor, high inflation can be the doomsday for any fixed income portfolio. Goods and services becoming more expensive erodes any fixed rate of return. The worst-case scenario is that price level growth rises above the fixed rates of interest being received from some asset in a portfolio (treasury bond, etc.) and then that asset quickly becomes highly undesirable to hold. This causes the prices of such assets to drop when inflation rises. High inflation is considered a sign of an “overheating” economy by the Fed, which could portend an increase in the Federal Funds rate (interest rate).

We should care about inflation, but for now we shouldn’t over-worry about it. Apollo chief economist Torsten Slok explained the cognitive bias of inflation quite well in a recent email:

Whenever we are in a recession, like we are at the moment, there is always a lot of fear of high inflation coming. Then once we come out of the recession, inflation expectations come down. In other words, markets are systematically wrong about inflation during recessions, and we see this cognitive bias play out again today.

Part 2

In Part 1 of this long analysis, we explained how inflation is determined by a basket of goods and services. Covid-19 caused surges in prices for certain goods, but we still see no signs of broad-based inflation.

Today we provide a brief overview of the arguments for higher inflation in 2021, which has been causing fierce debates between policymakers and investors.

What could cause high inflation in 2021?

1. Too much demand, too little supply

Businesses and suppliers in certain sectors would have greater pricing power if there is sufficient demand in post-Covid recovery. This point was made by former NY Fed President Bill Dudley in his recent podcast with Bloomberg. Some major sectors, like leisure and hospitality, have thinned down due to absent demand and financial distress during the pandemic. A resurgence in demand for these services could be met by a smaller number of businesses, who could take advantage of a less competitive landscape to raise prices.

Whether we’ll see great demand overwhelming supply is perhaps one of the most widely debated questions today. Fed Chair Jerome Powell addressed this issue during his press conference on 12/16/2020. The transcript below is selected out and edited by Apollo chief economist Torsten Slok for clarity:

QUESTION: Thank you, Mr. Chairman. Some forecasters have suggested that there is a lot of pent-up demand for travel and entertainment and services and that might stop being pent up in a hurry if we do get to a point where the vaccine is widely distributed. And that the beaten down service sector might have trouble meeting that demand in a hurry. How might that affect inflation in your mind?And would that be just a transient problem or something that might warrant closer scrutiny?
POWELL: So that has all the markings of a transient increase in the price level. You can imagine that as people really wanna travel again, let's say that airfares go up. But what inflation is is a process whereby they go up year upon year upon year upon year. And given the inflation dynamics that we've had over the last several decades, just a single sort of price level increase has not resulted in ongoing price level increases.
That was the problem back in the 1970s––it was the combination of two things. One, when unemployment went down and resources got tight prices started going up. But the second problem was that that increase was persistent. There was a level of persistence so if prices went up six percent this year they’d go up six percent next year because people internalize that they can raise prices and that it's okay to pay prices that are going up at that rate.
So that was the inflation dynamics of that era. Those dynamics are not in place anymore. The connection between low unemployment or other resource utilization and inflation is so much weaker than it was. It's still there but it’s a faint heartbeat compared to what it was. And the persistence of inflation if oil prices go up and then––that'll send a temporary shock through the economy. The persistence of that into inflation over time is just not there.
So what you describe may happen and of course we would watch it very carefully. We understand that we will always be learning new things from the economy about how it will behave in certain cases. But I would expect that that would be a one-time price increase rather than an increase in underlying inflation that would be persistent.
QUESTION: So––so not the kind of thing that the Fed would––would be trigger happy to––to––
POWELL: ––No––

Chair Powell provided some great reasoning as to why the inflation dynamics today are very different from that of the hyperinflation era in the 1970s – namely that even if a price level shock were to happen due to pent-up demand, it will likely be a transitory, temporary shock. We will explain more in Part 3 why inflation might continued to be muffled in 2021.

2. Surging commodity prices

Rising commodity prices coupled with Covid trade risk could cause “cost-push inflation.” If the input costs for raw materials go up, it will force the end products to be more expensive.

Prices for used cars and lumber have already skyrocketed during the pandemic, likewise with the price for cotton due to poor weather conditions. OPEC recently cut its daily output of oil barrels by 65,000, which has quickly pushed oil prices above $50/barrel for the first time since the pandemic began.

3. Supply chain constraints

In general, anything that could lead to higher production costs for goods could lead to higher inflation. Covid related risks could lead to various forms of supply chain restrictions. For example, the U.S. could restrict trade from Europe if their virus situation worsens or vice versa. If Apple is forced to move its factories away from China, or if Nike couldn’t get its shoes from Vietnam in time, these supply chain constraints could have profound effects on domestic inflation in the U.S.

4. Dollar depreciation

A weakening dollar could be a primary determinant of high inflation in the near-term. The dollar has depreciated rapidly since around May in the pandemic. With a weaker dollar, people overseas can purchase U.S. goods more cheaply with their local currencies. This could lead to higher demand for U.S. goods and cause domestic prices to quickly rise.

Likewise, a weaker dollar could also increase the costs of foreign goods, thus pushing up import prices and leading to higher domestic price levels.

See the dollar depreciation below of the WSJ Dollar Index, which measures the exchange rate of the dollar against a basket of other major currencies:

The dollar’s ongoing depreciation can mostly likely be attributed to a combination of low rates and low economic growth prospects that have lowered the global demand for the dollar, relative to other currencies.

5. Continued increase in money supply

A rapid growth in the money supply could boost inflation expectations. When the Fed purchases assets to support market functions, more money is injected into the economy, hence we say that the “money stock” or “money supply” have gone up.

The Fed’s substantial response to the pandemic in March has caused a massive spike in the U.S. money supply. The chart below shows the growth in M1 money stock (the liquid form of money, such as physical currency and demand deposits, not including savings accounts or financial assets) since 2019, which has gone more than doubled from about $3.6 to $6.8 trillion in 2020:

The Quantity Theory of Money (QTM) asserts that an increase in the money supply can raise price levels if the supply is growing at a faster rate than real output. This is not an unrealistic possibility considering how the world economic growth has slowed down dramatically.

However, Keynesian economists would argue the money supply itself is not a major determinant of inflation, and they’d point to demand-pull and cost-push inflation as the two main phenomena to consider.

We also haven’t seen this relationship play out for many years – the Fed has been “printing money” since the 2008 financial crisis, but the Fed has failed to reach the 2% inflation target in over 10 years. This is a worry, but it’s not an imminent risk on people’s minds.

6. Fed’s new “average inflation targeting” framework

We will discuss this idea in greater detail in another post, with more technical explanations of what the new framework is.

Part 3

In Part 2, we provided an overview of the arguments for higher inflation in 2021: too much demand met by too little supply; surging commodity prices; supply chain constraints; dollar depreciation; money printing; the new monetary policy regime switch to average inflation targeting.

We did not mean to scare you, and in fact we think it’s much more likely to see weak inflation in 2021, and here are the main factors keeping inflation low.

What could keep inflation low in 2021?

1. Slow vaccine distribution

It is unlikely that we will put the virus completely behind us anytime soon, partly because of the slow vaccination speed. Bloomberg has a “Covid-19 Vaccine Tracker” that tells us the current pace and completed cases of vaccinations. Vaccinations in the U.S. began 12/14/2020 with healthcare workers, and so far 6.25 million doses have been given. The pace is around 1 million doses given per week, which means it will take 10 years to reach herd immunity in the U.S. assuming a herd immunity threshold at 80%.

It's a two-dose vaccine. 80% of 330 million = 264 million. Double that is 528 million doses (528 million separate shots in arms). 52 weeks a year = 10 years.
— Leana Wen, M.D. (@DrLeanaWen) December 29, 2020

The virus itself is what will continue to cause high unemployment and shutdown of the service industry, and as you can see it is not guaranteed the vaccines will effectively mitigate a more aggressive spread of the virus in 2021. This could continue to have a depressing effect on the U.S. economy, reducing the chance of higher inflation.

2. Persistently high unemployment and weak labor market

Even if we successfully reach herd immunity by this summer, you cannot bring back the jobs lost permanently. 17% of all restaurants and bars (more than 110,000 establishments) have closed permanently during Covid; around 2 million restaurant jobs have been permanently destroyed.

The key statistics that we’ve iterated many times is that November still had 10 million fewer jobs than in February, and 1/3 of all job losses up to this point (at least 3.5 million jobs) are not going to come back in 2021.

The Phillips Curve shows an inverse relationship between inflation and unemployment – that lower unemployment rate would signal an overheating economy and push up inflation. However, unemployment continues to remain persistently high, around 6.7% in December. The Fed only expects the unemployment rate to decline back to less than 3.5% by 2023.

It will take several years before we return to pre-pandemic levels of employment. We’re still far from an overheating economy. See below for a plot of jobless claims that remain high above pre-pandemic levels:

Former NY Fed President Bill Dudley also noted in his recent podcast with Bloomberg that the “headline” unemployment figure likely understates true levels of unemployment. The reported rate, known as U3, only counts individuals who have been recently laid off and are actively searching for a new opportunity. Moreover, any individual who has become discouraged by the pandemic labor market and ceased looking for a new job will not be included in the percentage. It is likely the total number of Americans without jobs is underestimated, which further dampens the likelihood of any demand-pull inflation effects.

With a high number of people out of work, there is less potential for aggregate demand in the U.S. economy to rise and push up the price level for various goods and services.

3. Suppressed consumer spending

Even if the virus resides and unemployment drops to normal levels by this summer, the financial burden of the virus on households might still cause a lagged drawback in aggregate demand for goods and services. It’s not that consumers don’t have money to spend; it’s just the demand for services won’t pick back up anytime soon. For instance, air travel in the U.S. is now ~60% lower than a year ago, and it will likely not rebound back to the pre-pandemic level until 2022, so ticket prices will likely remain low.

In November, consumer spending had shown its first month-over-month decline of -0.4% since April. (See here for the November report from the U.S. Bureau of Economic Analysis.)

Generally, spending patterns could suffer if consumers find themselves struggling with employment and debt, like mortgages and credit card loans. On the other hand, spending could improve with support to households from the newly passed fiscal stimulus in December.

One common worry is that the American consumers will be inclined to spend less and save more after returning to normalcy, which is a hypothesis recently rejected by Goldman Sachs chief economist Jan Hatzius. It is more likely that spending will eventually return to the pre-pandemic level; it’s just it won’t occur until at least late 2021.

4. Zombie companies depress real economic growth

Persistently low interest rates could support “zombie corporations”, keeping real economic growth muted. The Fed keeping rates near zero allows access to cheap debt that many already indebted and low growth companies take advantage of, getting the name “zombie” from their tendency to be seemingly insolvent but barely survive.

Companies like these soaking up assets could ultimately drag on real economic growth and rising price levels. America’s zombie companies are racking up $2 trillion of debt, and an increasing number of firms have become “zombified” since the onset of the pandemic. With low interest rates projected until 2023, this situation could continue to worsen.

5. Supply chain constraints won’t push up too much inflation

In Part 2, we explained that inefficiency in global supply chains and rising commodities prices could both push up import prices and thus cause inflation in the U.S. However, one important statistic is that global trade volumes are now back at pre-pandemic level, which makes it much less valid to worry about higher inflation caused by supply chain weaknesses or declining supply of goods.

World trade volume rallies in third quarter after COVID-19 shock #WTOStats #GlobalTrade https://t.co/imwl76RzfK pic.twitter.com/bZpWEBnUSo
— WTO (@wto) December 18, 2020

Apollo chief economist Torsten Slok said in a recent email that the cost of transporting a container between countries has increased significantly in recent months, driven partly by strong growth in China, and high demand for goods in Europe and the U.S. However, the transportation and logistics costs are less than 10% of sales depending on the industry sector, so the impact on U.S. inflation is minimal. The U.S. economy is also much less dependent on trade, with imports only making up 15% of GDP (as opposed to 40% in several European economies).

Therefore, though many worry that supply chain constraints could push up prices for certain goods, they will not be a major source of broad-based inflation for the domestic U.S. economy.

6. Too much government debt

A large amount of government debt could have downward pressure on real economic growth and inflation, as exemplified by Japan. This is again another huge topic that we will discuss some other time.