Is inflation looming, or are we just seeing the market behaving as expected?
Inflation has been the word on the tip of many economists’ tongues recently. The price of many goods has risen rapidly recently, ranging from circuit boards and semiconductors to cheese and meats, and most critical, housing. Is this pricing increase inflation? The following summarizes the current inflation dynamic.
A little slice of Pi
- According to the US Department of Labor, consumer prices rose 4.2% in April 2021 YTD, the largest increase on record since August 2018.
- Supply chains have been running at reduced capacity and producer prices have risen as a result production falling below long-run efficient levels.
- However, massive increases in the government budget deficit via increased borrowing from the Federal Reserve has caused the economy to run a positive output gap, putting upward pressure on prices.
- Labor market recovery and levels of aggregate demand will likely be critical in determining the outcome of these conflicting trends.
Runaway housing prices
Housing markets are often used to gauge the health of the overall economy. Thus, current conditions might lead one to assume the economy is booming. For example, the Real Estate Rental and Leasing sector has recently experienced significant gains, with realtors and associated financial industries, such as mortgage brokers, poised for substantial growth. However, this may not be the case moving forward.
Due to rapidly rising home prices compared with the rest of the economy, some economists have hypothesized the US economy is in the grips of another housing bubble fueled by low interest rates, loose government monetary policy and a surge in urban flight amid the COVID-19 (coronavirus) pandemic. In 2020, the house price index grew 6.0%, followed by an estimated increase of 11.0% in 2021, and is expected to continue rising an annualized 3.5% over the five years to 2026. Housing prices rising at a faster rate than consumer prices and wages is a strong indicator that current growth is unsustainable.
Supply and demand rebalancing
Still, the US economy may simply be experiencing a short-term fluctuation in the housing market due to conflicting supply and demand dynamics. Current home inventories are at record lows, while the number of homes listed for sale has also sharply declined. Additionally, a limited supply of affordable single-family home constructions has skewed the supply dynamic toward luxury townhomes, vacation rentals and units generally marketed toward the top two income quintiles.
Amid a surge in residential building activity, as well as low production capacity in construction aggregates manufacturing during the coronavirus pandemic, residential construction materials have exhibited double and triple digit price increases in recent months. However, since aggregate construction prices are expected to rise at an accelerated rate compared with home prices, the case for the supply and demand rebalancing act seems to be tenuous at best, though this effect puts upward pressure on prices nonetheless.
Ice-cold economy
Some may think that since prices are on the rise the economy is red-hot; however, this is not the case and is actually a reflection of a cold economy. Prices rise as a result of increased scarcity. Due to the supply disruptions of many consumer goods during the pandemic, the economy has produced a lower real quantity of goods and services relative to demand, necessitating that prices rise.
In short, the economy stalled significantly during the second quarter of 2020 as a result of reduced production capacity and declining consumer spending. Therefore, rising consumer prices reflect this stalling out as manufacturers try to ramp up production to contend with the strong rebound in consumer spending, which occurred during the third quarter of 2020.
