SMITHFIELD, RI - We asked Bryant University Finance Professor Dave Louton to shed some light on inflation: the causes, effects, supply chain impact, and potential Fed moves moving forward. Here’s what he had to say. 

What is driving the inflation we are seeing now?

The two main forces currently driving inflation are the enormous waves of stimulus spending that have been applied to the economy over the past few years and the ongoing, mainly COVID related, supply chain disruptions that have led to scarcity induced price increases in many products. The unprecedented levels of stimulus and other emergency spending may have been needed, if not to stimulate demand, then to protect vital industries and stabilize household income during the initial economic shock at the onset of the pandemic. However, one inevitable side effect of this counter shock will be a tendency toward the acceleration of long-term inflationary pressures in the economy. 

The complexity induced by this confluence of inflationary pressures poses some unusual challenges for investors, policy makers and corporate decision makers.

At the same time, supply chain disruptions are leading to temporary shortages in the supply of certain goods and the resulting price spikes are feeding short to medium term inflationary pressures. These supply chain driven price increases tend to affect some industries and products significantly more than others.

Finally, there is mounting evidence that some proportion of the people who left the workforce over the past few years for COVD related reasons, will not be back.  That is an interesting story in its own right, but the immediate effect is an amplification of the upward pressure on wage rates created by other inflationary forces.

The complexity induced by this confluence of inflationary pressures poses some unusual challenges for investors, policy makers and corporate decision makers.

What will inflation look like over the medium to long term?

It is in the best interests of all entities with influence over supply chain issues to resolve disruptions as quickly and cleanly as possible, so it is reasonable to assume that those efforts will be made. 

It is not yet clear what the new equilibrium will look like, but it seems very likely that supply chain 2.0 will include more inventory buffering on the recipient’s end than has been the case in the recent past.

Over time, perhaps six to 18 months, they should be successful – barring further delays and disruptions related to the potential emergence of new COVID variants, which remains an important unknown factor in this situation.  The longer the supply chain disruptions last, the greater will be the pressure to build more robust and fault tolerant supply chains to replace the old systems, which were designed primarily to implement just-in-time efficiencies. 

It is not yet clear what the new equilibrium will look like, but it seems very likely that supply chain 2.0 will include more inventory buffering on the recipient’s end than has been the case in the recent past. If this shift takes place, it will impose higher inventory carrying costs on retailers and wholesalers, which will be passed along in the form of higher consumer prices. 

Ultimately, short-term supply chain disruptions will be resolved, but may still lead to some permanent upward price pressure, with the degree of that pressure yet to be accurately determined.  In addition, we will face the inherently long-term inflationary pressures associated with the fiscal policy choices of the past few years, shifts in the labor force and the infrastructure spending proposals which are currently under consideration.  As a result, we will most likely face significantly higher inflation over the short to medium term, dropping back to a new longer term inflation norm that is higher than the previous one due to the long-term inflationary pressures induced by recent policy moves.

The most important concern for the Fed should be to accurately distinguish between short-term and long-term inflationary forces and to resist the temptation to apply policy measures designed to address long-term inflation to short-term inflationary pressures.

What would an appropriate policy response from the Fed look like?

The most important concern for the Fed should be to accurately distinguish between short-term and long-term inflationary forces and to resist the temptation to apply policy measures designed to address long-term inflation to short-term inflationary pressures. The increasingly alarming recent inflation statistics may make it difficult to maintain the case for restraint.

To put this another way, the Fed’s response should be aimed at neutralizing long-term inflationary pressures, while leaving short-term pressures to be dealt with by other market forces. However, the Fed does not have an established history of correctly parsing and understanding the impact of complex supply chain issues on inflation, especially pandemic-induced supply chain pressures. To be fair, there is no precedent for this situation, at least not in the modern era of highly integrated supply chains.

The danger is that the Fed will either rely too heavily on the old rule book and end up over-responding to the inflationary pressures that are currently building in the economy.

The danger is that the Fed will either rely too heavily on the old rule book and end up over-responding to the inflationary pressures that are currently building in the economy. Or they'll attribute too much of the recently observed inflation to supply chain disruptions and under respond, which would allow long-term inflationary pressures more time to gain momentum and would ultimately make the process of reigning them in more difficult and more painful. So, we need the Fed to get this exactly right, which is quite a tall order.

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Dave Louton, Ph.D., Professor of Finance at Bryant University, is an expert in investment strategy, financial markets technology and innovation, asset allocation, mutual funds, options market models, investor behavior, and applications of computational linguistics and machine learning models to investment analysis. He has commented and contributed in major media including The Wall Street Journal, U.S. News & World Report, Yahoo Finance, The Hill, and more.