What a difference a year makes. A little over a year ago, the U.S. economy was reeling from the extraordinary measures taken to slow the spread of COVID-19: Businesses were shut, those that remained open were operating remotely or under severe constraints, air travel ground to a near halt, and we got to know our families a lot better. The U.S. government responded to this challenge with financial support on an unprecedented scale and breadth. Starting with the CARES Act in early March 2020, and continuing into the Biden administration, Washington has spent well over $5 trillion to preserve economic vitality and retain as many jobs as possible. At the same time, the Federal Reserve slashed interest rates to zero while buying close to $4 trillion of Treasuries and asset-backed securities to ensure that fixed income markets remained healthy and borrowing costs low.

It worked. After a record contraction of 31% in the second quarter of last year, GDP bounced back 33% in the third quarter, and by summer 2021 has regained all the ground lost during the pandemic recession, and then some. The National Bureau of Economic Research – the official arbiter of when economic cycles begin and end – announced that the recession that began in February 2020 ended in April 2020, setting a record for the shortest and sharpest contraction in American economic history.

As vaccination rates rise and life lurches back to a semblance of normality, the question now is what will be the economic price of this extraordinary government intervention. The federal budget has run a deficit of more than 10% for over a year, and the Federal Reserve has bought bonds and increased the size of its balance sheet by over $4 trillion since the beginning of the pandemic. Traditional economic theory holds that the inevitable price tag of deficit spending and excessive growth in money supply is inflation, and the bill has arguably already arrived.

The consumer price index (CPI) was up 5.4% in June 2021, and core prices (excluding food and energy) were up 4.5%. This is only the third month this century that a monthly CPI report has been north of 5%. Perhaps even more worrisome, producer price index (PPI) increases have hovered around 9% for the past three months. To the degree that producers are able to pass on these costs to consumers, it will add further pressure to consumer prices. Prices of basic commodities such as soybeans, lumber, oil and steel have risen sharply from pandemic lows, implying that there may be even more inflationary pressure to come as these prices feed through into end products.

The explanation for these price increases is found in the early chapters of any introductory macroeconomic textbook. Prices, whether for individual items or the economy as a whole, result from the interaction of supply and demand. For many months last year, demand was disrupted, as consumers were unable to spend money in normal ways. Yes, we could all surf Amazon from our couches and binge-watch Netflix, but we were not able to travel, go to restaurants, replace worn-out appliances, get our hair cut, and so forth. As soon as economies began to reopen, all of this pent-up demand was released. In economic terms, the demand curve shifted outward, leading to higher prices. Economic support programs such as enhanced unemployment insurance and direct stimulus deposits fueled this demand.

At the same time, supply chains around the world were disrupted by the economic response to the pandemic. We first saw this in the early days as paper goods disappeared from supermarket shelves, along with cleaning supplies and hand sanitizer. Even today, the disruptions continue, as (for example) the unavailability of computer chips disrupts the manufacture of new automobiles. Back to our economic textbook, all of this aggregates into the supply curve shifting inward. The combination of these two dynamics – more demand and less supply – naturally leads to inflation.

The critical question is whether this, too, shall pass, or whether these changes in supply and demand represent some sort of new economic normal. Our conclusion is that the current rise in inflation, as with so many other aspects of this most unusual economic environment, is transitory and will wane as both demand and supply return to more normal levels. In the paragraphs that follow, we consider several arguments for this conclusion, followed by a final observation that could prove this constructive outlook wrong.

Any year-over-year comparison of economic activity is subject to a base effect, or, the dominance of the starting point of comparison. The June inflation statistics shown in the earlier graph represent a comparison to summer 2020, in which economic activity was severely disrupted. One way to reduce the base effect is to consider a longer timeframe. For example, if we compared current price levels to June 2019, a more normal economic environment, we calculate that CPI inflation over the last two years has been a more modest 3.0% annualized. Producer prices were falling a year ago, so any rebound in 2021 is magnified by the same base effect. A similar two-year calculation shows that PPI inflation has been 3.4% over the past two years. In periods of economic volatility, it is important to rely on more than a single measure or single period for any calculation. Furthermore, as we get further away from the disruption of 2020, the base effect will moderate.

As noted, one of the primary drivers of the economic rebound has been strong household spending, a function of released pent-up demand. A primary objective of fiscal policy over the past year and a half has been to ensure that households had enough money to pay bills and spend, and this is reflected in the sharp rise in household savings.

In the nearby graph, the top line represents after-tax household income, and the bottom line indicates spending. The gap between the two, by definition, is savings. At several points over the last few quarters, aggregate household savings has risen to as much as $6 trillion to $7 trillion, always in conjunction with the implementation of an economic support package. This excess savings has been essential to the quick recovery of the economy, and the gap has now narrowed to $2.8 trillion (as of May). The pre-pandemic average was $1.4 trillion. If we assume that household savings revert to normal levels, there is an additional $1.4 trillion of excess savings to be spent, equivalent to about 6% of GDP. The tailwind is waning. In the absence of further economic stimulus, this should lead the demand curve to shift back inward as pent-up demand is met and household savings decline.

Similarly, as the global economy regains its footing, supply chains will heal, and the inflationary disruption from this quarter should ebb as well. This may take some months or even quarters to evolve, as it takes time for the economic shock of the past year to reverberate throughout the system. The transportation sector in particular remains quite disrupted; container rates are 350% higher than last July, adding to the cost of imported goods. Additionally, many companies are reassessing their reliance on single suppliers, or global supply chains that may be more fragile than anticipated. The demand curve is likely to return to normal more quickly than supply, but as supply chains evolve, the aggregate supply curve should shift back outward, relaxing the inflationary pressures currently in place.

The ripples of disrupted supply are evident within detailed inflation data. Inflation is calculated based on a hypothetical basket of goods and services, weighted according to the average consumption patterns of an American household. Historically, the correlation of items within the basket was quite tight; if one item was up 3% year over year, all the other items were up somewhere in this same neighborhood. Supply disruptions over the past 16 months have blown this correlation apart, with the result that the average measure of inflation might be very different from your experience of inflation, based on what you buy.

For example, the June CPI release reported that used car prices were, on average, up 45% in June. This one category alone added 1.4% to the headline CPI figure. Similarly, car and truck rental prices were up 88% year over year, and airfares rose an average 25%. Base effects, disrupted supply and higher demand all contributed to these eye-popping increases. On the opposite end of the scale, grocery prices were up a mere 2.4%, medical care services rose a scant 1.0%, and drug prices fell 2.0%. The point is that the range of inflation experiences varies dramatically, and as individual supply disruptions wane, headline inflation data should moderate.

Federal Reserve Chairman Jay Powell made similar comments in his semiannual monetary report to Congress in mid-July. In his prepared remarks, he observed that “inflation is being temporarily boosted by base effects,” while noting that “strong demand in sectors where production bottlenecks or other supply constraints have limited production has led to especially rapid price increases for some goods and services.” This supply-driven inflation should “reverse as the effects of the bottlenecks unwind.” Although it may be several months or even quarters before demand and supply return to more normal levels, the Fed does not believe that inflation is here to stay, and is therefore not inclined to raise interest rates and tighten monetary policy any sooner than needed.

Financial market participants seem to agree with this assessment. The New York Fed Survey of Consumer Expectations for June showed that contributors expect inflation to average 4.8% over the next year, but 3.6% over the next three years, consistent with a downward trajectory from current levels as base effects dissipate and the economy returns to a more normal path. Fixed income markets tell a similar story. Breakeven spreads – the difference in yield between the nominal U.S. Treasury security and the equivalent inflation-protected security – indicate that bond buyers anticipate inflation of 2.5% over the next five years and 2.3% over the next decade. This data is all consistent with a moderation in inflation from current pandemic-disrupted levels.

The hallmark of any good analysis is to understand what being wrong would look like. If this relatively benign analysis turns out to be wrong, it will likely be due to price inflation turning into wage inflation. Rising wages could prevent the demand curve from shifting back inward, as consumers spend their rising income. This could lead to the dreaded wage-price spiral, in which rising incomes lead to higher prices, which lead to demand for higher pay, and so forth.

Here, too, the recent data is frustratingly volatile, reflecting disruption in the labor market, which is perhaps the most important supply chain of all. Average wages rose sharply last year, due entirely to the concentration of job losses in lower-income sectors that were unable to pivot to remote work. As economies have reopened and employees are returning to work, average hourly earnings seem to be returning to more normal average levels. At 3.6% in June, the rise in average hourly earnings does not indicate that general inflation is bleeding into the labor market, but we should watch this measure closely as the labor market continues to heal in the second half of 2021.

This expectation of more modest inflation in the months ahead does not warrant complacency. Inflation at any level poses a risk to the long-term objective of preserving and growing the purchasing power of a portfolio. Investors are generally familiar with the miracle of compounding – how a small amount of money, at even a paltry rate of interest, can compound into great wealth over time. Inflation is this engine in reverse. Even modest inflation can erode the purchasing power of money unless hedged through appropriate asset allocation and security selection. A moderation in inflation may not capture the attention of headline writers, but investors should pay heed even as inflation returns to normal.

References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.