In the children’s book “Snow” by Uri Shulevitz, the story starts with gray skies and no precipitation. Then one snowflake falls. A child reacts excitedly – “it’s snowing!” - but an adult dismisses it as just one flake. Then there are two snowflakes, and then three. The child expresses delight but each time is told by an adult it is nothing and will melt. Even the news declares that there is no snow. Finally, the snowfall picks up, and the town is covered in snow.
There were flakes of inflation throughout the second quarter skies. Prices at both the consumer and producer level surged, in some cases by an amount not seen in decades. The Case-Shiller home price index rose 14.6% for the year ended April, the fastest growth since the measure was created in 1987. The median existing-home sales price rose 24% year over year in May. The story of rising prices has been playing out for months, and the adults at the Federal Reserve (the “Fed”), and many commentators, are dismissing it as “transitory.” Chairman Powell assures us that these rising prices are no big deal and that the Fed has the tools to manage inflation, even though it is reacting far later than it has in the past to such risks.
It is possible they are correct that this inflation is temporary. Supply bottlenecks resulting from labor shortages and other factors have thrown off the supply/demand equilibrium for various products and services. Contributing to this is pent-up demand that is being unleashed by an economic reopening and additional demand provided by stimulus checks and enhanced unemployment benefits. These factors will surely abate. But there has also been rapid expansion in the money supply. It’s impossible to know how much of the recent acceleration in prices is due to the transitory factors and how much is due to too much money in the system or other secular forces. It’s also hard to know to what degree such inflation may become embedded into people’s expectations, which is the real risk because a pervasive belief that prices will consistently rise perpetuates the problem, as employees routinely demand wage hikes, stores systematically raise prices, and so on. There has been upward pressure on wages recently, given the labor shortage. This may ebb to some extent as people come back into the labor force, but there may also be some contributors to the acceleration in wages that are more permanent in nature.
For what it’s worth, market-based measures of long-run inflation expectations are elevated but have recently come down a bit. This decline may have helped fuel the rotation in the second quarter back to the beloved growth stocks, which outpaced the value stocks by a significant margin for the three months, ending a two-quarter losing streak. While some of these growth companies have solid fundamentals – and we invest in a few - our sense is that many continue to be pushed to extreme levels by loose Fed policy, low long-term interest rates, and other factors.