MARKET COMMENTARY

The Great Inflation Debate

As opinions fly about the prospects for inflation, we take a closer look at what inflation is and how it can affect your pocket and your portfolio.

04.28.2021 - Giles Marshall, Vice President, Portfolio Manager,

Are we or aren’t we about to enter an inflationary environment? After experiencing a long period of disinflation (falling inflation), the debate over the path ahead has become a defining investment theme in 2021.

We tend to take the word inflation for granted, but what is it? In short, there are two ways to look at inflation.

  • The first refers to the rise in overall prices for a set of goods and services in an economy, as measured by a basket of goods such as the Consumer Price Index (CPI). Canada’s CPI covers items across eight categories, ranging from food and shelter to alcoholic beverages, tobacco products and recreational cannabis.
  • Rather than monitoring price changes of hundreds of items, you can also look at inflation as the decline in purchasing power of a given currency over time. This second definition may better encompass inflation since it implicitly includes asset-price inflation, which the CPI does not.

Either way, inflation and its causes are not especially well understood, quite likely because it has been scarce—at least in the developed world—except during periods of war and from the late 1960s through most of the 1970s. Since then, as the Canadian CPI graph shows, we have experienced 40-plus years of declining and steady inflation. This is mainly due to technology, globalization, favourable demographic trends, deregulation and debt accumulation.

A Surprising Path

Following the 2008-2009 Global Financial Crisis (GFC), when central banks worldwide adopted aggressive monetary policies—such as quantitative easing (QE), and zero and negative interest rate policies—it was widely expected inflation would return. It did not, for reasons that remain central to the current debate. In fighting COVID-19, central banks have been far more coordinated and resolute in deploying aggressive monetary policies than post-GFC. Perhaps more importantly, recent monetary policies have been accompanied by extraordinarily expansionary fiscal policy, aimed mostly at replacing income at this point. In time, spending will likely broaden to include infrastructure and other expenditures.

Certain CPI components, especially on the goods side, are already showing year-on-year price increases as input costs have risen. Given the deflationary nature of the first several months of the COVID-19 lockdown, we expect inflation to almost certainly increase by mid-2021 due to year-on-year base (comparison) effects. Given the combined monetary and fiscal policy mix, it is possible that we may see inflation rise for a sustained period; however, the debate is far from settled. Excess capacity, elevated unemployment and the disinflationary force of technological change are likely to counterbalance the policy mix.

While CPI inflation may well recede later this year, applying the broader measure of inflation (which captures rising asset prices), I think it is fair to say we have all been living with inflation for a considerable period of time; there is that sense your dollar no longer has quite the same purchasing power. We know inflation has positive and negative implications for equities and fixed income assets and will continue to monitor the situation closely. As the debate regarding inflation’s direction unfolds, you may find this theme becomes part of our portfolio conversations with you.

Inflation in Canada, Year-Over-Year Consumer Price Index Change, January 1945 to February 2021 graph.

 

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