There has been a lot of discussion in the news and among financial professionals about whether inflation is a real threat to our economy, or if the current price increases are just a short-term consequence of the economy restarting after more than a year of on-again, off-again lockdowns due to the pandemic. Because we are all inundated with more information than we can handle, it can be difficult to cut through the noise and get a clear picture of what is actually happening. Therefore, we would like to provide you with a summary of how Stratus analyzes the price increase information we are hearing.
In our opinion, one of the most important distinctions to make is between relative price changes and aggregate price changes. For example, when there is an instance of food contamination, such as E. Coli in spinach, consumers shift their behavior and buy substitute products like kale. Therefore, we would expect the price of spinach to drop and the price of kale to increase. These price changes reflect the changes in demand for these specific products. If you look around the economy, these relative price changes occur all the time based on the supply of and demand for various goods and services.
In comparison, aggregate price changes reflect an overall trend (up or down) of prices in the economy based on producers and consumers expectations for the future. For example, if consumers expect that prices will increase across a broad range of goods, they will buy those goods now to try and lock in lower prices. Seeing this increased demand, producers will increase prices accordingly to try to match their supply with consumer demand. The combination of consumers expecting higher prices and producers expecting higher demand can lead to a self-reinforcing cycle where prices for all goods and services rise.
The key for anyone who owns assets, whether a business, stock, or home, is to take some time to think about what is happening in the micro-economy and not get caught up in the “herd mentality” that can lead to a self-reinforcing increase in aggregate prices. For example, as the pandemic swept across the U.S. last year, it led to tremendous disruptions in all sectors. In the lumber industry, sawmills reacted to the shutdowns by cutting production, which is reasonable in a normal recession brought on by decreased demand. However, with everyone at home and looking to create home offices, school rooms, and outdoor entertainment areas, the demand for lumber accelerated, and the decrease in supply combined with this increase in demand has led to skyrocketing prices.
If we look closer at the example of lumber prices, we can see that the current inflated prices have more to do with supply than demand. If a contractor wants lumber for framing a new home or renovating an existing home, the lumber is available – just not at a price that is favorable. This is the law of supply and demand in action. As supply works to catch up with demand, there will be a relative increase in the price of lumber. Once sufficient supply is available, the price of lumber will reduce as the increased supply will cover more of the built-up demand.
In conclusion, we would encourage any asset owner to think about the specific reasons why the price of a certain product or service is increasing. Our economy is a complex system, and trying to determine whether there is runaway inflation based on the relative adjustment of prices at a microlevel is not helpful. Following a period of economic volatility, it will take time for the supply and demand of certain products and services to reach equilibrium. During this period, prices will move based on the ongoing interactions between producers and consumers, and some prices will necessarily increase rapidly. What will help us navigate the current inflation-focused financial commentary is to remember that a relative change in price as supply and demand work toward equilibrium is much different than a psychological anticipation of aggregate price increases for all goods and services in the economy.