Inflation Sparks Debate Over Whether Current Price Conditions Are Transitory or Long-Term
The markets started 2024 with cautious optimism due to fears of more rate hikes as the Fed tries to battle inflation. So cautious are the markets that even positive news like strong retail sales are not triggering any rallies in the market. That’s because the markets are cautious that such positive numbers point to resilience and could incentivize the Federal Reserve to raise interest rates.
For someone new to the financial markets, it’s only natural to wonder what causes inflation and why it has so much power over the financial markets. Answering this question can help settle the ongoing debate on whether the prevailing high inflation numbers are transitory or long-term.
What is Inflation?
Inflation measures the rate at which the prices of goods and services go up over time. While inflation is good for asset value appreciation, it adversely affects the economy if it rises too fast and negatively affects consumer purchasing power.
Is the current inflation transitory or long-term?
To answer this, it is essential to understand the leading causes of inflation. There are two types of inflation, namely: Cost-push inflation and demand-pull inflation. Cost-push inflation occurs when the cost of factors of production goes up, forcing producers to pass the same to consumers.
On the other hand, demand-pull inflation happens when there is more money in the economy than there are goods and services to buy. The excess liquidity in the market pushes up the cost of goods and services as the market tries to find equilibrium.
The case for inflation being transitory
From the above understanding of the causes of different types of inflation, there is a strong reason to believe that the current inflation rate is transitory. That’s because the current market conditions can be traced back to 2020 and 2022.
After COVID-19 struck and major economies shut down, the global supply chain was disrupted. This means that the movement of goods and services globally has been disrupted. At the same time, in a bid to keep economies afloat, Central Banks turned on the printing presses in 2020.
While supply chains were starting to return to normal in 2021, the Russian invasion of Ukraine created new disruptions to oil supply chains. This has created a scenario where commodity prices are on the rise due to high costs of production and shipping and more money in the economy than goods and services.
However, the world economy has factored in the war in Ukraine, and production is normalizing. At the same time, the consistent rate hikes that started in 2022 have mopped up most of the liquidity in the economy.
It is safe to speculate that the current inflation is transitory, and things could normalize within 2024.
The case for inflation being long-term
While the pandemic and the war in Ukraine may have fueled a spike in inflation, it is notable that inflation was expected to become an issue way before it happened. That’s because, since 2008, interest rates in all major economies have remained at zero. This saw a ballooning of asset prices to a level whereby 2020, analysts were already talking of an everything bubble.
This means asset prices were close to their peak, and the excess liquidity was bound to lack a place to go. For an issue that has been growing for over a decade, it is ambitious to expect short-term measures to reverse it.
At the same time, the ongoing decoupling between the US and China means commodity prices will only rise going into the future. As such, the current high inflation levels could remain so despite moves to raise interest rates.
The impact of inflation on different sectors of the economy
Inflation affects different sectors of the economy in different ways. Some sectors may benefit from inflation, while others may suffer. For example, companies that sell commodities like oil, metals, or food may see their profits rise during periods of high inflation, as the prices of their products increase. On the other hand, companies that rely on borrowing to fund their operations may struggle to service their debts if interest rates rise along with inflation.
Inflation can also affect consumers differently depending on their income, spending habits, and assets. People with fixed incomes, such as retirees or low-wage workers, may feel the pinch of inflation more than others, as their purchasing power erodes. Meanwhile, people who own assets like stocks, real estate, or precious metals may benefit from inflation if the value of their assets rises faster than the inflation rate.
How investors can protect their portfolios against inflation
Investors can take several steps to protect their portfolios against inflation. One common strategy is to invest in assets that are expected to rise in value along with inflation, such as commodities, real estate, or inflation-protected bonds. Another strategy is to diversify one’s portfolio across different asset classes and regions, to reduce the impact of inflation on any single investment.
Some investors also choose to hedge their exposure to inflation by using derivatives such as options or futures. For example, an investor who owns stocks in a company that may be vulnerable to inflation may buy put options on those stocks, which would give them the right to sell them at a predetermined price if their value falls below a certain level.
In conclusion, the current debate over whether the prevailing high inflation numbers are transitory or long-term is fueled by several factors. While disruptions to the global supply chain and excess liquidity in the market have contributed to the recent spike in inflation, the ongoing decoupling between the US and China and the long-standing issue of low-interest rates may keep inflation levels high in the long term. The impact of inflation on different sectors of the economy and consumers varies widely, and investors can take several steps to protect their portfolios against inflation, including diversifying their investments and investing in assets that are expected to rise in value along with inflation. As the situation continues to evolve, investors and market participants will need to stay vigilant and adapt their strategies accordingly.