Here's Why Inflation Is Like a Game of Tag

The Federal Reserve keeps clinging to the hope that inflation will be transitory. So, let's examine some common reasons given for why inflation could subside on its own. Understanding each of these can help investors better ascertain how persistent inflation will be, and therefore how quickly world central banks may reverse course and start hiking rates. More balanced spending between goods and services will ease supply chain constraints Since the onset of the COVID pandemic, consumers have shifted their spending habits to favor goods over services. Total U.S. spending on goods has increased 24% vs. the 2019 average level, while spending on services has only increased by 6%. This outsized increase in goods spending has undoubtedly contributed to the supply chain squeezes. Perhaps that's why the personal consumption expenditures price index for goods has risen by 6.1% while services has only risen by 3.5% in the last year. One might suppose that as the pandemic subsides people might be more willing to spend on services (such as going out to eat) and hence spending on goods vs. services would become more balanced. In theory that could reduce supply chain problems and perhaps ease inflation pressure. While this narrative is logical, it doesn't hold up well upon close examination of the data. First, this shift in spending toward services is already happening. According to the Bureau of Economic Analysis, in the last six-months goods spending is flat and services spending is up 6%. And yet there's no sign that inflation is subsiding. That is likely because goods spending isn't declining, but rather services spending is catching up. Hence there's just as much pressure on the supply chain for goods. Meanwhile, the increase in services spending is probably exacerbating wage pressures. Labor costs tend to be a major (if not the dominant) component of the cost of service providers. So if spending on services continues to climb, it will only increase the demand for labor, which as we all know is already in short supply. Lastly we should consider that while services inflation is lower than that for goods, it is still 3.5% over the last year. That is way higher than what the Fed is willing to tolerate over the long-term. In my view, it is better to think about consumer spending in general outpacing the economy's ability to supply both goods and services. Any theory about inflation subsiding meaningfully has to start with consumers spending fewer nominal dollars in general. A mere shift in wallet share isn't going to do the trick. Supply chain problems are easing on their own There is indeed some nascent evidence that supply chains are healing. For example, this week a Morgan Stanley research report wrote that Malaysian semiconductor production for autos was back to 100% capacity. The delivery time measure from the Empire Manufacturing report declined in November, although is still quite elevated. It always made sense that the pure pandemic-related supply chain problems would eventually get solved by the free market. What isn't going to get solved is if demand is so strong that it is overwhelming the world's ability to produce and transport goods. It is one thing for the supply chains to get back to their pre-pandemic production capacity, it is quite another to expand to meet a wholly different level of demand. Take the well-publicized delays at ports. The reality is that many major American ports are handling more cargo than they've ever handled before. The problem isn't that something has gone wrong at the ports, the problem is they aren't set up to handle this volume of traffic. In other words, it is mostly a problem of too much demand. The chart below shows the total volume of containers passing through the ports of Los Angeles and Long Beach. I've marked the average monthly volume from 2019 (green) and the average from July 2020-current (red). The average monthly volume from mid-2020 to now is 20% higher than the 2019 average. Source: Port of Los Angeles, Port of Long Beach Stimulus boosted savings, but this source of spending is running out Six months ago I thought the huge spike in retail spending was fueled by a combination of stimulus checks and pent-up demand from COVID lockdowns, and that once that had all burned off, spending would revert to something like the pre-pandemic trend. That isn't happening. Tuesday's retail sales report showed overall spending at an all-time high, and still rising, despite stimulus checks being long in the rear view mirror. Source: Census Bureau A related claim is that elevated consumer spending has been boosted by excess savings that are now being spent down. The idea is that when COVID was at its worst, people held onto money they might have allocated to eating out or traveling, and now all that money is getting spent. This argument makes sense, but held more water six months ago than it does now. The next chart shows total personal savings. We can see it is down to a pretty normal level: The most recent level of $1.3 billion is just above the 2019 average of $1.2 billion. Source: Bureau of Economic Analysis Bear in mind that the retail sales figure released this week covers October, while this last savings figure was from September. So the most recent spending data stemmed from a time when consumers started without meaningfully elevated savings levels. There is a much simpler explanation for why consumers continue to spend at such an elevated pace. Wage income is surging. The chart below shows the 12-month sum of tax withholding from regular wages from the Treasury Department. This report is released daily so gives us a very good window into current wage trends. The chart shows an unprecedented ramp of tax collections, indicating that wages are rising rapidly. Source: Treasury Department As long as consumer income keeps growing, this high level of spending will be maintained. Until the economy's ability to produce and deliver products catches up with this level of demand, I think inflation will remain elevated.

Here's Why Inflation Is Like a Game of Tag

Until the economy's ability to produce and deliver products catches up with demand, here's what's likely to play out.

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