One of the objectives of our blog is to encourage people from both sides of the ideological divide to understand and appreciate views that are not commensurate with their own and help forge a consensus on greater number of issues.
The good news: we did that in our last post. However, how we got there was far from ideal!
Most of our readers vehemently disagreed with our view that inflation has already peaked, is currently receding, and why it will continue to do so over the foreseeable future. In fact, the pushback was so impassioned that we felt compelled to respond to the main points of contention in a follow-up piece.
We Disagree With TQC
The primary pushback on our thesis was that while our inventory destocking argument resonated – and was in fact buttressed this past week by Target, which issued a rare mid-quarter press release stating they planed “additional markdowns” to clear excess inventory - we did not address the rapidly rising cost of energy, specifically gasoline. Other points of reader pushback related to rising home heating and AC bills, soaring food costs, and higher wages.
Our critics’ arguments were supported on Friday when the U.S. Bureau of Labor Statistics released its latest figures for the Consumer Price Index (CPI). The CPI calculates the change in prices paid by the U.S. consumer for a basket of goods and services. Friday’s figures showed inflation running at an 8.6% annualized rate, the most elevated reading since 1981. Ouch!
The national average cost of a gallon of regular grade gasoline is $5.00, compared to $4.37 one month ago and $3.07 one year ago. Natural gas is close to $9/btu, up 130% since January. The price of corn, soy, wheat, and other foodstuffs are all up materially over the last few months. Companies are being forced to raise wages and lower standards to fill a plethora of open positions.
That said, how can we say inflation has peaked when it costs well over $100 to fill up an SUV and the price of gasoline shows no signs of abating? How can we argue inflation will recede in the future when it appears that it will cost homeowners twice as much to cool their homes this summer? Indeed, if we expect the rate of inflation to moderate (and believe inflation is indeed transitory), why are the cost of various food staples substantially higher? How will wage pressure subside when the current labor shortage is compelling companies to fill jobs that require a college degree, by an applicant with a GED?
Goods & Services
The answer is multifaceted. First, despite the public (and pundits’) fixation on the retail price of gasoline and other commodities, the fact is that today the United States economy is primarily underpinned by services, not manufacturing or agriculture.
Energy (which of course includes gasoline) accounts for only ~8% of the CPI; food is ~11%. Furthermore, the United States is more energy efficient than at any time in its history.
Over the last four decades American economic output expanded by ~300%, however demand for energy grew only ~50%. To help put these figures into context, consider the following data compiled by the bipartisan, Alliance to Save Energy:
“On a per capita basis, U.S. energy productivity and efficiency gains have muted the growth in energy use that might be expected as Americans have become more prosperous. Despite the growth in average home size, more and bigger vehicles driven more miles, and the rapid growth in all kinds of energy-consuming devices, from air conditioners to computers to air travel, energy used per American has actually decreased over the last several decades. In 1970 Americans consumed the energy equivalent of about 2,700 gallons of gasoline per person for all uses of energy. That rate of consumption extrapolated to our current economy would have come to the equivalent of about 5,400 gallons per person. Instead, 2010 consumption was the equivalent of 2,500 gallons per person.”
At TQC, our intention is not to minimize the pain at the pump (and the grocery store) that American consumers are feeling. That pain is real, especially for individuals in lower tax brackets who spend a higher proportion of their disposable income on gasoline, and we acknowledge it. Our point is that while gas prices are high and will most likely remain so for the foreseeable future (more on this below) comparisons to the energy induced inflationary shock of the 1970s and suggestions it portends a decade long period of elevated inflation are inappropriate. Unlike in that era, America is not a highly energy intensive nor dependent economy today.
Shortages & Gluts
Second, we must consider an important yet neglected defining feature of pandemics: they create shortages, which drive prices up, and gluts, which drive prices down. Compounding this phenomenon is that our modern day, just-in-time supply chains were not designed for abrupt changes in consumer demand. At the onset of the coronavirus pandemic, consumer behavior turned on a dime. People bought more (consumer goods) and did less (traveling, commuting, etc.).
In our previous post, we used hand sanitizer as a poignant example. Remember, during the initial covid wave there was a surge in demand for hand sanitizer. Producers could not ramp production fast enough to satisfy demand. Prices skyrocketed. After the initial covid wave receded, demand for hand sanitizer plunged. Prices collapsed.
The inverse happened regarding air travel. When covid first reared its ugly head, demand for air-travel plummeted. While it suddenly became difficult and expensive to buy hand sanitizer, it was easy and cheap to purchase an airline ticket. Airlines responded by aggressively slashing the price of tickets. Pilots, flight attendants, and support staff were furloughed. Other employees were enticed with cash offers to retire early. Planes were grounded and flights were canceled.
Today, consumers are all busting out of covid quarantine simultaneously. People are buying less consumer goods (which is why retailers are seeing massive inventory builds) and doing more traveling and entertaining. International travel is back to pre-pandemic levels. Business travel is also recovering. This is creating a surge in demand (and higher prices) for travel and entertainment and an acute shortage of workers to cater to this sudden influx of customers.
This past week, the Wall Street Journal penned an article on U.S. regional airports that service smaller cities. Many large carriers are greatly reducing service to these destinations or ending it all together. Normally, regional airlines would happily fill the void. Instead, they are being forced to curtail service too.
How could this be? Why would major airlines cut service to various cities if demand for flights was increasing? Furthermore, why wouldn’t regional airlines swoop in and seize the opportunity to take market share? The reason is that there is so much demand for flights into and out of major cities, that Delta, American, United, etc. - the same airlines that were offering tickets for a pittance and encouraging pilots to retire early when covid began – are desperately recalling those employees, re-allocating resources to higher volume routes, and poaching pilots of regional carriers by offering cash bonuses and higher pay. As a result, smaller airlines like SkyWest and Republic simply do not have enough pilots; some smaller cities risk losing all commercial air service.
Situations like this are transpiring all over America. This is creating wage pressure and an abnormally low unemployment rate. However, when demand trends normalize – and in time they will - wage pressure should subside.
Rear View Mirror
Thirdly, the CPI is a lagging economic indicator. It reports prices that were paid last month, not what they will be next month, or next year. Fortunately, financial instruments exist that represent investors’ expectations of the rate of inflation for various durations in the future. Even after Friday’s elevated CPI figures, investors “expect” inflation 24 months in the future to be 4.40%, just > 3% in 5 years’ time, and < 3% a decade out.
Specific inputs that constitute the CPI (energy, commodities, etc.) can – and very well might continue to trend up - even though the overall rate of inflation can – and in our view will – subside.
It is timely to note that while we did not address energy and gasoline in our last post, we dedicated an entire issue to the subject a few months ago.
In that piece, we argued that unlike in the past, producers would be loath to increase output in response to higher prices. We wrote:
“Despite tangible improvements in the energy mix, the stark reality is that fossil fuels still generate over 80% of the world’s power. Meanwhile, a combination of low-hanging fruit for politicians, litigation, regulation, and public shaming has resulted in a reduction of fossil fuel investment by ~40%, in less than a decade…When fossil fuel investment is curtailed, output will decrease. When output decreases, if an alternative fuel source cannot be utilized, a shortage will arise. When a fossil fuel shortage arises, the price will increase and will continue to rise until the benefit of investing and producing more of it, outweighs the potential political, legal, regulatory, etc. cost incurred of doing so.”
Unfortunately, that is precisely what is playing out today. Despite record prices for crude oil, the drilling rig count in America is ~1/3rd below its 5yr peak. Predictably, some of the same politicians that vilified oil companies for drilling in the past, are vilifying them for not drilling now.
To help curb the price of oil, the government pledged to release 50 million barrels of crude oil from the Strategic Petroleum Reserve (SPR). Unfortunately, this is tantamount to passing gas – no pun intended - in a windstorm. The United States consumes ~21 million barrels of oil per day. Domestic oil and gas companies produce ~12 million barrels of oil per day. A 50-million-barrel release of crude oil from the SPR might be good for optics, but it amounts to just ~2.5 days of U.S. consumption, or ~a week of imports.
Regrettably, the oil (gas) price will probably have to rise even higher to induce oil companies to increase output.