The Federal Reserve estimates a settling of rates in 12-18 months because, fundamentally, rising prices will cause producers to adjust their production. Factories will produce enough computer chips, sawmills will produce enough lumber to meet demand, and the labor force will return to places of work. The core supply-demand imbalance will clear out in due time.
The Quirk of Q2 2020
Q2 2020’s depressed inflation rate is reflective of the economic conditions of the very beginning of the COVID-19 pandemic. Major behavioral shifts, such as the elimination of commutes for many people, led to buying patterns experiencing major changes virtually overnight.
Frankly, the majority of this shift came from price changes in the auto and oil markets, which caused a disproportionate skew in the Consumer Price Index. Consumers purchased substantially less gas as many commuters shifted to working from home, eliminating their commute. At the same time, car rental companies liquidated their fleets as travel plummeted, further saturating the low-demand auto market (specifically the used car market).
This substantial rate drop was then counteracted with a steep increase, pushing the rate to 5% Q2 2021 over Q2 2020 as the economy rebounded and demand for a whole host of goods and services increased along with it. Specifically, this was best reflected in the aforementioned energy and auto prices due to supply chain issues. With car prices up 21% and energy prices up 25% from April 2020 to April 2021, Forbes reports that energy and oil prices are substantially skewing the CPI upward. In fact, some estimates place these anomalies as accounting for 3% of the 5% increase.
As we have seen, while gas prices at the pump fell to a low of $1.84 per gallon in Q2 2020, they have now recovered to their pre-pandemic, Q1 2020-equivalent prices of around $2.50-$2.80 per gallon. Gas prices generally adjust quickly: production is not labor intensive and can ramp up and down in short order. This is while cars, where production is suffering from capacity reductions, furloughs and the infamous chip shortage, are priced significantly higher than pre-pandemic levels. The market is equalizing, and transitory changes are slowly but surely evening out.
Clearing Backlogs in the Supply Chain
A major reason for the high inflation rate today is the supply-demand imbalance resulting from supply chain disruptions. When the COVID-19 pandemic began, industries from lumbermills to chip manufacturers reduced their output as orders dropped off. Less than a year later, demand picked up substantially as the economy rebounded. But supply of goods has not kept up, and prices for all manner of goods have increased substantially.
This is a shock, not a long-term trend. Supply chains will ramp back up to meet consumer demand, the economy will stabilize, and inflation rates will drop back to normal levels.
The Federal Reserve has said that for most of 2021, inflation will continue to climb as global supply chains struggle to keep up with an uptick in consumer demand. Their expectation is that as supply backlogs begin to clear, inflation will settle back down over the next 12-18 months. The Fed is predicting that this will bring the inflation rate close to its annual target of 2%. That being said, the Fed’s struggle to boost inflation to the 2% level over the last decade led the central bank to announce that it would temporarily allow higher inflation “for some time” in order to reach the 2% on average goal[1].
[1] CNBC – https://www.cnbc.com/video/2021/08/15/what-the-july-2021-cpi-and-ppi-report-tells-us-about-the-housing-market.htm
Core Inflation Rate (excludes volatile food and energy)
Market realities change inflation rates, but so do market predictions. If consumers believe that prices will continue to go up, their present buying behavior may change. Stockpiling, holding off on capital expenditures, and keeping assets for longer are all logical behaviors in such a situation. For now, we can expect to see prices continue to rise as global supply chains continue working towards stabilization. When supply chains stabilize, the national economy should see healthy movement and avoid a long-term inflationary period, because eventually the signaling created by the price spikes will cause producers to figure out how to expand capacity. This will clear the backlog of the past 12 months.
Current Trends in Employment: Pandemic Parents and Recent Graduates
Part of what is driving the supply chain shortage is a fundamental withdrawal from the labor market. In February 2020, the total employment in the United States sat at 152.5 million. By April, total employment reached a low of 130.1 million. Total employment has recovered significantly since then, but still falls short of February 2020 levels by about 5.3 million workers. That shortfall is about equivalent to the entire labor force of the LA area dropping out of the labor market. With the economy recovering and employers hungry to hire, this labor deficiency is not due to a lack of jobs: workers are withholding from participation in the labor market.
For young professionals and those without children, the flexibility of working from home has been an exciting proposition. Working remotely from anywhere with half-decent Wi-Fi is an exciting opportunity for someone solely responsible for their own well-being.
This is not necessarily the case for parents. Working from home has put a disproportionate amount of stress on parents maintaining a balance between work and home. For those without the financial means to bring on extra help to care for their children, the possibility of a two-income household has become increasingly less realistic.
The pandemic made it functionally necessary for some two-income households to become single-income households. Any family that had the financial ability for one person put a hold on their career did so during the pandemic. Because the income of the second earner is taxed at the highest marginal rate, the cost of paying for additional help may, in many cases, have outweighed that second income. Beyond that, the lower expense structure that many families had during the pandemic made this decision easier. Parents who assumed full-time childcare duties are far less likely to go back to work until they know that their children’s situations are secure (which we define as children going back to school without fear of schools closing back down).
For older children, specifically college graduates, 2020 had a major hiring hole as most companies went on a hiring hiatus during this period of economic uncertainty. With hiring hiatuses lifting and the labor market leaning in workers’ favor, many of these college graduates are not seeing an urgency to return to work. Many feel that a higher-paying job is just over the horizon, so it is best to hang back for another month (or three).
This has further raised the hurdle for getting into the workforce, as many of these graduates left their metropolitan areas after graduation and moved back home since they could not find a job. Now there’s an additional cost barrier of moving into a city that is preventing them from looking for jobs.
Beyond the decrease in job opportunities, the classes of 2020 and 2021 are anecdotally smaller than the class of 2019. Many of these students decided to defer their graduations because there were no jobs or because they were forced to extend their education as a result of school closures. This has caused a major shortage of professionals with 2 years of experience. Similar to the supply chain for goods, the supply chain for labor was disrupted and it is going to take time for these students to enter the workforce.
Current Trends in Employment: The Service Sector Workforce
The other segment of entry level workers largely impacted by COVID-19 was in the service sector. Very few service sector jobs pay more than $25 an hour, and with high pandemic-induced unemployment benefits, there is little financial incentive for people to return to workplaces. During the pandemic, additional Federal compensation from December 2020 to September 2021 meant that California residents could claim up to $750 in weekly benefits. With benefits extended up to 53 additional weeks, many potential members of the workforce took the opportunity to stay out of the market and on an alternative income stream. Factoring in the costs associated with traveling to and from work, the opportunity costs of full-time employment, and the risk of contracting COVID at work, it is no wonder many were not willing to work for less than $20 an hour.
Beyond that, unemployment benefits were given to independent contractors for the first time in history, adding a large number of people to the unemployment benefit pool. All of this, paired with an unprecedented eviction moratorium, has provided few incentives to the labor force to reenter the workforce with urgency. If eviction is off the table, and there is still a consistent form of income for expenses, why should anyone work?
Statistics show that these trends in unemployment are beginning to reverse course with an end to the pandemic in sight and unemployment benefits discontinuing in September. This will lead to a more engaged workforce, which should help stabilize the labor market shortages contributing to inflation.
Inflation: a Double-Edged Sword
In real estate, there are two conditions that allow inflation to work to a property owner’s benefit: fixed debt and, in California due to Prop 13, limited real estate tax growth. When there is inflation, assuming that rental income and expenses grow at the same rate, the property will experience disproportionate NOI growth. For example, during a 10% inflationary period in which a property’s rents and expenses rise in tandem (but for legally fixed or limited expenses), cash flow would increase by 23%.
This is why short bouts of inflation can be real estate’s best friend, and it is especially true when the federal reserve is effectively trying to keep real interest rates below 0%. This is what we have seen in the majority of developed economies over the last decade.
Conclusion
We are amid a brief, but steep, increase in inflation rates. Backlogged supply chains and a hesitant labor force are currently pushing up the consumer price index, but in 12-18 months supply and demand are expected to largely equalize. As restrictions lift, confidence increases, and unemployment benefit programs end, the labor pool is expected to increase as well.
This period of high inflation is a shock, not a trend. With stability likely on the horizon, long-term investments in California real estate remain secure and consistent. We should soon see a reversion to historical inflation rates consistent with those of the previous decade.