Inflation That May Actually Inflate

All those closed businesses and the cratering economy forced the Federal Reserve to step in.

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By Simon Constable

Inflation. It looms in the closet of many national economies, waiting to burst out like some dreaded ghost. It has brought even economies as great as the United States to their knees; back in 1971, President Richard Nixon was forced to freeze all salaries and prices because of it. Since then, it hasn’t said boo for decades, rising at only about 2 percent annually in the US since the 1980s. COVID only kept it away even more—crushing the rate to nearly zero.

But while almost everyone is hoping for an economic rebound this year, don’t count on inflation to help out. Indeed, economists believe it could throw a huge curve for many companies’ plans. The seeds for all this were planted last year by two events. One caused the overall inflation rate to drop—spurring a second event that will likely propel it back up in due course.

The initial event was the global pause in economic activity that came from government-imposed lockdowns at the start of the pandemic. “Get the picture in your mind of the factory gates being chained shut,” says Steve Hanke, professor of applied economics at Johns Hopkins University. That means you had many things that couldn’t be bought or sold, causing prices to spiral or remain stagnant. Inflation in the US dropped to an annualized rate of 0.1 percent in May 2020, down from 2.5 percent in January. (Of course, there were some flukes; don’t tell anyone who fled a city to buy a little house on the prairie that prices were down!)

But all those closed businesses and the cratering economy forced the Federal Reserve to step in and prop things up with one of the bigger bond-buying programs in history. Quickly, that led to a surge in the money supply. According to the Center for Financial Stability, a key measure of broad money surged a record-breaking 31 percent last June versus its level a year before. From May through November, the increases were between 22 percent and 31 percent, which represents a massive leap from the usual year-on-year increases of around 4 percent to 5 percent.

Much as we hope they do, surging money supplies like that don’t go away; they eventually lead to more inflation prices. “There’s always a good correlation between growth in broad money and inflation,” Hanke says. How much inflation will rise is hard to estimate, but already prices for a broad basket of commodities have surged, some to near-record levels.

None of this is good news for businesses. Executives will face whether they can pass on the higher costs to consumers via increased prices. Just as the pandemic bifurcated companies broadly into “haves” and “have nots,” so will the rise in inflation, says Art Hogan, chief market strategist at National Securities Corporation. “Inflation is only a problem if you can’t pass that along,” he says. “If you are Apple or Nike or any household name or brand that has pricing power, you can raise prices.” Of course, other companies won’t have that power to raise prices, and they will see their profit margins squeezed.

In addition, it looks likely that the cost of borrowing money will increase. That’s because investors who lend money want to get compensated more when inflation is higher. The baseline cost of borrowing—the amount the government has to pay to borrow money—has already risen since last year, as market participants anticipate the probable surge in inflation. Those rates look set to double versus their level in 2020. Ultimately, when government interest rates increase, so do everyone else’s. “If you are not sitting on a war chest of capital, those costs are going to go up,” Hogan says.