Inflation is a difficult concept to grasp, but it can be understood as the devaluation of currency. It’s an economic phenomenon that occurs when the overall price level rises and prices increase at a faster rate than wages or other forms of income.
The how to prepare for inflation is a blog post that discusses the ways to save money and invest in case of inflation.
This year, I’ve focused a lot of attention on the dual risks of increasing inflation and rising bond rates. When you add in rising energy costs and the possibility of Christmas shortages, it may seem like everything is going wrong. However, there is a strong argument to be made that two decades of low production are going to end.
The fundamental argument is that businesses are investing again, and that increased capital expenditure leads to increased production. The headwinds that held down spending in the last two cycles—caution after the dot-com bubble burst and a shortage of credit after the 2008 financial crisis—have dissipated. Companies also have a strong incentive to spend since labor is no longer cheap, with salaries increasing rapidly and businesses experiencing recruiting problems.
Simply put, money is plentiful, but labor are few, therefore investing in equipment makes sense.
Data on new capital goods orders indicate a massive increase as the rebound from Covid-19 took root, after a considerably lower drop than typical during the recession—excluding the unpredictable orders for airplanes, which dropped significantly last year. In nominal terms, new orders hit their greatest level on record in June, excluding aircraft and military expenditure (military spending does not boost productivity); adjust for inflation, and it looks less good, but still better than the five years before to the epidemic. According to S&P Global, the similar trend exists in much of the globe, and 2021 will see the largest increase in global capital expenditure since 2007, the last economic cycle’s high.
According to Ian Shepherdson, chief economist at Pantheon Macroeconomics, capital expenditure in the United States dropped considerably below its usual pattern over the past economic cycle, and businesses must make up—something they had already begun to do before the epidemic.
“There’s a lot of things that has to be done,” he adds, “since there was a huge backlog in the previous cycle because everyone was traumatized.” To increase efficiency, businesses must replace outdated cars, machinery, and computers, as well as purchase new equipment and software. One tiny example: as a result of the health issue, restaurants are increasingly accepting orders online.
If this bull case is correct, it will enable wages to grow faster without causing inflation, since wage increases will be offset by productivity improvements. Instead of a 3% pay raise, salaries might grow by 4% per year if productivity increased to 2% per year from the 1% it averaged from 2010 to the pandemic. We could celebrate salary increases of little over 4% instead of fretting about them.
Last week, Richard Clarida, the vice chairman of the Federal Reserve, highlighted increasing productivity as one reason to believe inflation would be transitory, albeit the hypothetical figures he used were wages rising by 3.5 percent and productivity rising by 1.5 percent. Because both average and median earnings are already over 4%, productivity would have to rise to 2% each year to keep inflation in check.
If the Biden administration’s reduced $1 trillion plan for infrastructure investment goes through, as well as the European Commission’s €800 billion ($930 billion) investment program, productivity may be boosted much further.
The International Monetary Fund is optimistic that the pandemic’s forced shift would boost productivity as well, owing to increasing use of remote labor and electronic payment and automation.
Sadly, none of this is guaranteed. For starters, increased capital expenditure may not be sustained. During the recovery from the financial crisis, there was a rise in capital expenditure as well, although it did not last. Things have changed: In contrast to now, high unemployment meant minimal wage pressure back then, and weak banks limited companies’ access to loans. The second major reason was that the economic recovery did not last, causing businesses to rethink their expansion plans—and there are still plenty of risks to growth.
The Biden administration’s proposal to invest in infrastructure may increase productivity.
Jonathan Ernst/Reuters photo
Second, rising prices are already diluting greater capital expenditure. Because new vehicle prices were 10% higher in September than they were in September 2019, businesses looking to upgrade will see some of the productivity gains of a new van or truck eaten up in the cost. In general, the pandemic put a stop to a 25-year decrease in the price of imported capital goods, with the exception of automobiles. Price reductions may continue, but if equipment costs more, businesses will gain less productivity.
Third, increased capital expenditure may not result in increased productivity. This may seem silly—after all, that is the entire point—but much capital expenditure will be used to address issues that might otherwise cause more problems, such as climate change, shifting supply chains away from China, and increasing corporate crisis resilience. Productivity may be greater than it would be otherwise, but it is not always higher than it was in the previous decade.
Fourth, government expenditures may not be very effective. The transportation infrastructure in the United States is in urgent need of repair, and it will almost certainly boost production. However, the $550 billion in additional money over five years equates to 0.5 percent of GDP each year, which is good but not transformative.
Finally, focusing only on the pandemic’s productivity-enhancing benefits is too optimistic. Covid-19 also left us with a burnt-out healthcare staff, millions of patients suffering from lingering illnesses, and a multitrillion-dollar debt hangover, none of which will help.
Investors who believe in the bull case should be less concerned about inflation than the rest of us, and should buy cheap cyclical stocks that have lagged in the last decade, while avoiding bonds, Big Tech, and the quality stocks that have performed well while overall productivity has remained stagnant. The bull tale is interesting, but it’s all hope at this point.
James Mackintosh can be reached at [email protected]
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