Inflation explained

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   By Guest Blogger Ryan Lewenza

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As financial analysts trying to predict and profit from the financial markets, inflation is one of the most important variables thatwe need to track, especially now. Inflation trends drive central bank monetary policies (i.e., interest rates). Inflation can impact profit margins and corporate profits. It can have an impact on our spending habits and therefore economic growth. As an investor there are few things that are as important as inflation so today, I’m going to do a deep dive on it.

Inflation is clearly top of mind right now among consumers, politicians, central bankers, investors et al. But it hasn’t always been this way. Prior to this recent surge in inflation, inflation had gone into hibernation for much of the 2000s. We basically tamed it, as seen in the chart below.

Inflation during the 2000s was very orderly and contained around the 2% target level for central banks. There were numerous factors that led to these lower inflation levels including technology advancements, which increased productivity, globalization and the rise of China and its incredible manufacturing base, which resulted in lower priced goods that we purchased here in North America, and an aging population with older people generally consuming fewer goods. All of this led to a period of price stability and what was coined as the ‘Great Moderation’.

This all changed in 2021/22 as inflation surged to the highest levels since the late 1970s and early 1980s. The pandemic was a major factor that ignited the inflation surge as consumers quickly changed their spending habits, buying goods online, which led to supply chain issues.

Governments and central banks responded to the pandemic by doling out billions of dollars in support and stimulus, which helped to revitalize the economy but also greatly contributed to this inflation rise. As the economy recovered from the worst pandemic in a century, and the labour market rebounded strongly, all this demand helped to drive commodity prices higher. Wages then started to pick up due to the strength in the labour market and the rising prices, creating a ‘wage-price’ spiral. All of this led to the highest inflation seen in decades.

So, that’s how we got here. Let’s now dig into the details around inflation.

Global inflation levels

Source: Bloomberg, Turner Investments

The Bureau of Labor Statistics in the US and Statistics Canada in Canada are responsible for tracking and publishing the monthly inflation reports. The monthly CPI reports include two main inflation measures – headline inflation (includes everything) and core inflation (excludes food and energy). Each month these agencies report month-over-month and year-over-year figures, with economists and investors parsing through all the details.

Inflation is broken into three broad components – durable goods, nondurable goods and services. Durable goods are those products that are expected to last for an extended time (generally more than three years) such as automobiles and dishwashers. Nondurable goods or consumables are those goods that are consumed quickly and have a short lifespan. This includes things like food, gasoline and beer. And the services component includes things like communications (our cell phones) and transportation.

Inflation is then broken into further groups and categories. The US CPI, for example, includes over 200 different categories. The BLS then weights all these different categories based on what the average American spends money on. Below is a chart that shows the breakdown of each category weight in the CPI measure.

The biggest category by far is shelter, which accounts for 32% of the overall CPI inflation measure. This makes obvious sense since mortgage or rent payments represent the largest monthly expenditure for most people. After that we get food at 14% and transportation at 8%. The BLS regularly reviews the CPI basket and will adjust these weights as spending habits change.

Weights of different expenditure categories in US CPI

Click to enlarge. Source: US Bureau of Labor Statistics

Moving on to the drivers of inflation. There are numerous factors that impact inflation and below are the key ones:

• Demand-pull inflation: This occurs when demand outstrips available supply which leads to prices getting ‘pulled’ higher.
• Cost-push inflation: Cost-push inflation occurs when supply drops due to some external factors (e.g., labour strike, resource shortages, a pandemic). With demand remaining constant and the lower supply, this leads to higher prices.
• Monetary and fiscal policies: An increase in government spending and deficits can be inflationary as it increases demand for goods and services. Central banks are responsible for the level of interest rates and partly for the money supply (the Treasury department is officially responsible for the money in circulation and printing), which can have an impact on prices. Look at the hyperinflation examples of Argentina, Zimbabwe and Germany in the 1920s.
• Exchange rates: Changes in foreign exchange rates can have an impact on inflation by influencing the prices of imported goods. A weaker currency makes imports more expensive, which can contribute to inflationary pressures.

Finally, if inflation is so important what models or tools exist to help predict inflation? The two most common macroeconomic models used in predicting inflation are – the Phillips Curve and the Output Gap Model. The Phillips Curve was created by an economics professor at the London School of Economics in the 1950s, and he found there was an inverse relationship between wage inflation and the unemployment rate. When the unemployment rate is low this points to a strong labour market, which boosts wages and therefore overall inflation.

The Output Gap Model compares potential GDP, which is a theoretical estimate of the value of output produced if labour and capital were employed at their maximum rates, to real GDP. When real GDP is above this ‘potential’ GDP, then inflation is likely to rise and vice versa. The main issue with this model is that it’s based on a theoretical estimate which can be difficult to determine/calculate.

So, there you have it! Yes, this is not the most scintillating topic or blog, but hopefully this 101 tutorial on inflation has been helpful and informative. Next time I’ll review the inflation outlook and implications on the equity and bond markets.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.