But, instead, what his plan brought to the fore was the sharp increase in the prices of the components he needed to make his dream a reality. As he embarked on this sizable investment, he found himself mulling over the causes of the inflationary pressures and wondering how long they would last. And he asked himself, "Should I wait or forge ahead?"
For many people, seeing their purchasing power eroded by repeated increases in the prices of the products and services they consume is a new phenomenon. The last time the average annual change in Canada’s Consumer Price Index significantly exceeded its 2% target was back in the early 1990s! So it’s only normal to wonder whether inflation is back with a vengeance or we’re just seeing another temporary fluctuation.
How is inflation measured?
The Consumer Price Index (CPI) estimates changes in the cost of living for the majority of Canadians. It measures changes over time in the price of a fixed basket of goods and services, such as housing, food, transportation, leisure, furniture, apparel and other everyday items purchased by individuals. To determine its monetary policy, the Bank of Canada uses a series of core inflation metrics to eliminate specific effects and focus on the underlying trend. The total CPI is commonly used as a general measure of inflation.
Transitory or persistent?
The meteoric rise in the crude oil price from 2009 to 2011 and its impact on the cost of transporting other products, such as commodities, helped push the total CPI above its target and fuelled investors’ fears of inflation early in 2010. At that time, the monetary authorities reassured us that the increase was transitory, and history proved them right.
Today, central bankers are once again offering the same commentary, telling us that rising prices are temporary. They think today’s inflation is largely due to the "pandeconomic" recession we have just experienced. Forecasting inflation is complex, so let’s dive in and analyze each of the factors that support or challenge the narrative of the world’s major central banks.
There are, without a doubt, many indications that the surge of inflation is due to the global pandemic that hit the economy and is still affecting it to a degree. The base effect1 caused by the sudden shutdown of economic activity during the first wave has definitely had an impact. Lockdowns have also contributed to a scarcity of labour in some industries. Prolonged stimulus measures, the reskilling of some workers and the early retirement of others have all contributed to the shortage. The transition to remote work has revealed a lack of microchip production capacity on a global scale. The loss of cargo space caused by the grounding of passenger flights and the shortage of shipping containers have disrupted supply chains. So the question is: To what extent and at what rate can the inflationary phenomena caused by the pandemic be reversed?
As stated at the outset, excessive inflation has not been a problem for a very long time. In fact, since 1991, when the Bank of Canada established a framework for targeting and containing inflation, downward forces have been top of mind for economists. The causes of these pressures are known, but is their effect always the same?
- Technological advances enable us to lower production costs through productivity gains. This has always been the case, even though some periods have generated fewer discoveries than others. Even though we can debate the actual contribution of some technologies to our productivity, they have always been a deflationary force.
- The aging of the population has long been singled out as a cause of disinflation. A greying population consumes less, saves more and therefore does not put as much upward pressure on demand and ultimately on prices. Japan often serves as a case in point. Ever since the demographic curve was cited as a cause of deflation, it has continued to evolve; moreover, its impact could abate – for example, as it increases wage pressures related to labour shortages.
- When you think of all the inexpensive goods that come to us from China or elsewhere, it’s easy to understand that this long trend toward globalization has been a profound source of deflation over the past 30 years. Even so, the tide already seemed to be turning long before the pandemic: since the great financial crisis, nationalist policies have been gaining in popularity and statistics indicate that globalization has reached a tipping point, as illustrated by world trade as a percentage of GDP.
Emergence of new dynamics
Beyond the slowing of certain structural deflationary forces, our need and collective desire for greater social justice and our consideration of environmental impacts in modes of production are other factors that will contribute to higher inflation in the medium term. Thus, despite what is seen as transitory inflation, it is conceivable that the longer term will bring us a higher level of inflation that will not be seen as problematic by political decision makers or the population in general. Given the massive debt levels that governments have run up, higher inflation will be in their interest because it increases GDP faster and reduces the debt-to-GDP ratio. The key is to ensure that it remains under control.
To that end, central banks will eventually have to tighten monetary conditions. The return of inflation may prove to be the long-awaited opportunity to normalize interest rates. It should therefore not, from the outset, be perceived negatively. The many years of accommodative policies since the great financial crisis have created excesses, such as rock-bottom bond yields and pricey real estate. We should also bear in mind that it is precisely because of a lack of inflation that the monetary authorities have maintained their accommodative bias.
If structural forces are, indeed, leading us into an environment where inflation and higher interest rates help correct some imbalances, investors will need to make sure they aren’t caught flat-footed by the readjustments.
How to manage inflation risk in your portfolio?
Beyond trying to predict inflation itself, an effective strategy calls for a wise selection of securities that are better able to withstand inflation’s adverse effects. For example, many well-managed companies have a greater ability to pass cost increases on to their customers. This phenomenon is called pricing power: a company’s ability to raise prices above inflation without affecting sales or losing customers. This ability to dictate prices is obviously not absolute, and the degree to which companies can exercise it varies. What is clear, however, is that pricing power is an attribute of companies that see a constantly growing demand for their products or services, have few or no rivals and operate in an industry with high entry barriers.
An experienced manager can identify such companies and build a portfolio that will preserve asset values. A good example is Mastercard, which operates in an industry with high entry barriers and benefits from higher prices because its fees are based on a percentage of transactions made. Conversely, companies operating in sectors where prices are regulated are not able to adjust the fees they charge to match the increases in their expenses and, therefore, find themselves losing out in an inflationary environment. These examples illustrate the importance of having world-class managers who can adapt your portfolio to changing market conditions and risks.
Getting a clear picture
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