I recently had the opportunity to Zoom with noted economist Professor Professor Peter Linneman. In our wide-ranging conversation, one topic we discussed at length was inflation. Given the relevance of this topic to all of us today, whether as investors or consumers, I’ve summarized Professor Linneman’s take below in this article. I always find his insights illuminating and thought you may as well.
The U.S. rate of inflation hit 7% in December 2021, its highest level in nearly four decades. With prices soaring so rapidly, the question on everyone’s mind is whether inflation is temporary or here to stay.
Never has the word transitory, which the Federal Reserve used for a time to describe inflation, taken on so much meaning. When economists like Professor Linneman refer to inflation as transitory, what they are actually saying is that the price hikes of 2021 were not caused by monetary forces — and as a result, inflation will fade as supply and demand come back into a more normal situation.
The inflation we are experiencing today is very. But it’s also useful to understand how this round of price volatility compares to the past. This level of inflation last occurred in the 1970s and early 1980s, and it’s important to note that the 1970s flavor of inflation is much different from today’s.
What happened in the 1970s was not that supply went down. Capacity did not shrink, other than the supply of oil. But because the central bank printed a lot of money, demand went way up — because essentially everybody wanted to get rid of their money.
This level of pandemic-era inflation we are encountering today is not about a whole lot of money chasing goods. This time around, inflation is about a normal amount of money chasing an abnormally low amount of capacity.
Go back to the start of the pandemic, at the end of February 2020. Supply and demand for most goods and services were in decent balance. Then the pandemic came, and demand stayed the same but supply fell 2% to 30%, depending on the product. Prices had no other no other place to go but up, and the goods that experienced bigger capacity reductions went up more. And if there was a capacity reduction for things people really wanted or needed, prices shot up most significantly.
But all capacity constraints aren’t created equal. Say there’s a shortage of bubblegum, and producers triple the price of gum. Most of us will just say, “No, thank you – I don’t really need to chew bubblegum.” But there are other items in the economy for which buyers are willing to pay more if prices rise.
Imagine a home that costs $300,000 to build, but it’s not sellable unless it has a doorknob — and a doorknob normally costs $60.
The builder needs the doorknob to free up their carry cost on $300,000. If capacity for the doorknob is cut back, does the builder care how much they pay? $65? $70? $80? In the big scheme of things, the builder is willing to pay even 30% more because, when compared to the $300,000 they gave invested in the house and the need to sell the house, that sum is nothing.
The crucial point about the doorknob is that if for a builder, if everything else in the house is available but the doorknobs, they haven’t got a house. That is to say, the demand for the doorknob is inelastic.
What happens in the doorknob example is not driven by the demand side. It’s all about the supply side.
Our current inflation is driven by the shrinkage of capacity, which was caused by two different phenomena. One was regulatory government restrictions. In China, ports closed, so goods couldn’t get out. In Vietnam, a giant Samsung factory, about an hour and a half out of Hanoi, was shut by government mandate for something like three months.
The second part is in March through July of 2020, everybody said, “Hoard cash. Don’t ship anything, because I don’t know if they’re going to pay me. Let people go. Let the truck drivers go. Let’s stop all construction.” And so capacity was cut back voluntarily in the face of the shutdowns and COVID.
Even if capacity fell only a couple of percent for doorknobs, they are still going to be big price increases. That doesn’t unwind overnight, but it is transitory.
Lumber is a perfect example. Before the pandemic, lumber was at $340. By late 2020, lumber had soared to $1,800 — all because of capacity. To get their development fees, home builders need lumber, so they’re willing to bid up the price.
Lumber has come back down to around $540. Lumber is still very expensive. Fair enough. However, compared to $1,800, which is where it was at a year ago, it’s come way down, and it’s going to come down more as capacity comes back.
That’s what you’re going to see all across the economy over the next two years. Going forward, inflation will be all about capacity. As more comes online, prices will moderate. However, if we got more shutdowns, we’re going to get more capacity reductions and thus more price increases.