Updated: Jan 5
November 2nd 2021
Written by Conor O'driscoll
One topic that has become extremely prominent this year is inflation. After laying dormant for many years, the inflation rate has climbed to its highest rate in decades. However, inflation, the different sources of inflation, and how to measure inflation is commonly misunderstood.
What is Inflation?
Inflation is simply an increase in prices. In most years, aggregate price levels increase across the economy. The inflation rate, on the other hand, is the percentage increase in prices versus the prior year. Some years are faster or slower than others. The Federal Reserve (often referred to as “the Fed”) aims for inflation to average 2 percent over the long run. This is important because the Fed have a high degree of power to control interest rates, which they use to achieve their economic goals.
Inflation that is too high can be a heavy burden on households and individuals. On the other hand, economists often see inflation that is too low as a symptom of an economy that is not growing at its full potential. The last time sustained negative inflation was seen in the United States was during the Great Depression of 1933. More recently, low inflationary periods have been linked to low economic growth, particularly in Japan and Europe.
How is Inflation Measured?
Inflation is measured by using government surveys of pricing across a wide variety of goods and services. There are two main statistics used: the PCE (Personal Consumption Expenditures) Inflation Index and the CPI (Consumer Price Index).
The CPI gets much more attention because it is released sooner but the Fed looks more closely at the PCE because it uses a more comprehensive set of goods and services and the make-up of goods and services used are updated more frequently. As of August of 2021, the rate of CPI inflation is 5.3% and the rate of PCE inflation is 4.3%. Historically, the CPI inflation rate has been 0.5% higher than the PCE.
The rate of inflation tends to be quite volatile as key components, such as energy and food, can have big and unpredictable swings. Food and energy prices are notorious for huge movements that are all but impossible to predict reliably. Upswings and downswings can also reverse quite dramatically. For this reason, economists also look at a statistic called “core inflation” which excludes food and energy. While this does not give the full picture of the last 12 months, it is generally a more reliable predictor of how inflation will look in the next 12 months. The CPI Core rate was 4% in August 2021 while the PCE Core rate was 3.6%.
What Are the Causes of Inflation And How Do They Impact Businesses
There are two primary drivers of inflation and both are relevant today:
1. Cost-push inflation
2. Demand-Pull inflation
Cost-push inflation is inflation that results from a reduction in the supply of goods and services. It is called this because it is often linked to increases in the cost of raw materials and labor, which results in a lower supply. As the cost to a business to provide a good or service increases, they must choose whether to increase the price that they sell for or to keep their prices the same and receive a reduced profit margin. The answer often lies somewhere in between. A crucial factor in determining the answer is the bargaining power of the business. The more the end consumer wants or needs their particular product over an alternative, the more the business can pass on the increased cost. In finance, this is often referred to as a moat. Businesses obtain a moat through quality, differentiation, and the cost to the consumer of switching to another (in time and money). As an example, a pharmaceutical company can build a moat by creating the best possible drug for treating an ailment and obtaining a patent to prevent competitors from copying their treatment.
While cost-push inflation often gets the most attention, demand-pull inflation is just as important for understanding the full picture. Demand-pull inflation results from an increase in the demand for goods and services above supply. Generally, what happens is that economic growth from increased investment and growing employment causes an increase in spending but production capacity cannot keep up. In this case, businesses face a different decision. They must choose between increasing prices to increase their profit margin or keep them the same and sell a higher quantity. Again, the answer often lies somewhere in between. Businesses with a larger moat often enjoy the best of both worlds with higher margins and volume. Of course, it is often more complicated than this because each business also faces their own set of supply constraints.
How Does Inflation Affect Markets?
The relationship between inflation and markets is complicated. As discussed above, there are different causes of inflation and each industry and business reacts differently. While increased costs can be a hindrance, the ability of businesses to increase their prices to offset cost increases can often be a positive for the stock market during inflationary periods. The complicated nature of this relationship is apparent when looking at historical data of past inflation spikes.
Trying to distinguish patterns in historical stock market data to predict future stock market performance is often a fruitless exercise as the dynamics are constantly in flux. But at the very least, this data is striking.
Inflation has become an important topic this year for daily life and markets. Understanding inflation, how its measured, the different types of inflation, and how it impacts markets are crucial aspects of investment planning. It is important to stay logical and remember that as with any market, while there is always risk, there is also opportunity.