Scarcity strikes back!

• Scarcity took center stage last week
• Scarcity in product markets driving up prices
• Scarcity in labor markets challenging employers
• Retail sales pause, but still look record-setting
• CRE should seize opportunity presented by inflation concerns 

Data released last week reaffirm that one of the fundamental ideas of economics still holds: scarcity. On a basic level the economy concerns production, consumption and allocation because we do not live in a world of infinite resources. But the tricky part about scarcity in economics?  The interplay between supply and demand remains complex, a general theme that keeps popping up.

Scarcity as inflation

Inflation concerns started sprouting up even before last week’s data, which further exacerbated concerns. We recently addressed this topic in March, but it warrants discussion again after updated inflation data. The consumer price index (CPI) and producer price index (PPI) data from April both exceeded expectations. Headline CPI hit its highest monthly rate since 2009 while core CPI hit its highest monthly rate since 1982. Headline PPI followed a strong March with a strong April. And import prices in April also grew at a robust pace. What’s going on here and how do we view this? A few key observations:

1. Base effects – Growth versus prices last year appear large because of starkly low prices in 2020 due to economic weakness, producing a low denominator for calculating change. That tends to overstate inflation in the short run.
2. Increasing demand – From both government policy and the release of pent-up demand from funds that did not get spent over the last 15 months, demand is now increasing at a brisk rate. Demand can rebound quickly, but vaccination and the unique nature of the crisis means demand is now returning at a more rapid pace than during many recoveries.
3. Increasing supply – Supply is also increasing as more of the economy is brought back online, but this lags behind demand growth. This typically happens during recoveries, but the unique nature of this crisis, creating both voluntary and involuntary supply bottlenecks, will take longer to rectify. It is always easier to take supply offline than to bring it back online.  

What does this mean for inflation? 

These impacts should abate over time. Base effects will moderate, simply by dint of mathematics, as prices rise, increasing the denominator. Pent-up demand will revert to more stable levels. And supply bottlenecks will lessen and eventually end as more supply gets brought back online. This happens during a typical recovery. But magnitude and timing differ this time because of the unique nature of the combination of factors above. We expect this recovery-oriented inflation to reach levels unseen for many years (this is already occurring) and even once things settle down for inflation to remain sustainably above levels that many have gotten used to over the least 12-13 years. We still expect more durable inflation to migrate toward 2.5%-3.0% over the medium term. But we also do not foresee 1970s-style inflation, producing widespread economic damage. Moreover, the incredibly robust economic growth this year and next should more than capably handle stronger inflation. In short, our view remains unchanged – greater inflation than we have seen in years, but not great enough to bring about widespread economic damage on its own. 

We also see inflation rebounding faster than during a typical recovery. Typically, though not always, the highest year-over-year inflation readings occur at the end of expansions. Even during the last cycle, inflation peaked earlier in the recovery, but was accelerating heading into the pandemic. Something similar could play out this time – a burst of inflation as the economy recovers, a period of settling, and then acceleration toward the end of the expansion. Therefore, we caution against reading too much into timing differences as well as differences in magnitude. 

Scarcity as labor shortage

We also see scarcity in the labor market. As of the end of March, a record 8.2 million open jobs existed, roughly matching the number of jobs net short versus the peak from last February. Before the pandemic, we had written about and discussed this shortage and our view that it would only get worse in the future as baby boomers continued to retire and exit the labor force. It seems as if the future is now. With resurging demand, accelerating baby boomer retirements over the last year, some workers sitting on the sidelines for a variety of reasons (see our discussion from last week), labor supply relative to demand has reached new record levels of scarcity. While some have grown concerned about this producing a wage-price spiral, we see a few forces mitigating this including the use of one-time bonuses (versus more sustained wage increases) and increased adoption of automation and technology, another theme of ours. 

What else happened last week

Retail sales came in below expectations with flat growth for April. While we still believe that March is likely the high watermark for month-over-month growth, especially with the upward reversion to the March data. At 10.7%, March’s month-to-month growth rate, fueled by robust fiscal stimulus, vaccination and reopening of some of the economy, exceeded retail growth for many calendar years. While we remain optimistic about retail sales for the balance of the year and still expect a record year for retail sales growth, topping March’s growth rate, the second-fastest ever, should prove challenging. Relatedly, consumer sentiment also declined in early May, but we see this as a temporary blip. 

|  What we are watching this week  |

Residential real estate activity will dominate the calendar this week. We anticipate little meaningful change from starts and permits in April, with strong demand for housing offset by rising prices for important inputs. Existing home sales for April also should change little, with risk to the downside, Incredibly tight inventory for sale limits growth in the market. 

|  What it means for CRE  |

Commercial real estate (CRE) holds a golden opportunity this cycle to reintroduce itself as a partial and even imperfect inflation hedge. Over the last 12-13 years since the financial crisis, inflation remained subdued. An entire generation of CRE market participants has heard more about the benefits of this inflation hedge than seen it in practice. At a minimum, this narrative presents CRE with a great marketing strategy, especially during a period of policy uncertainty. CRE never turned in its inflation-hedging credentials and now seems a good time to brandish them again. If the CRE market cannot capitalize on concerns (warranted or otherwise) about inflation during this cycle, we will have only ourselves to blame. 

|  Thought of the week  |

According to a study from the consultancy McKinsey & Company, replacing an employee costs 20% to 30% of annual compensation, versus retraining an employee which costs less than 10%.