5 Factors Driving Higher Inflation & What You Should Do to Prepare

For the last month or so, as the stock market rally has faltered, and longer-term interest rates have increased by more than 50% since the start of the year, the concerns and whispers from the market over higher inflation have grown louder and louder. So what exactly is inflation? Why are people suddenly more worried about it now than before? And, most importantly, what can you do to protect your family finances from it?

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What is Inflation in Simple Terms?

Before we can dig into higher inflation concerns in more detail, we all need to be on the same page about exactly what inflation is... in the simplest of terms, inflation is a general increase in prices.

Think of everything you buy for your family in a given month - groceries, utilities, gas for your car, health insurance - it's typically a very similar basket of goods and services every month. Inflation measures how the prices of that basket change from month to month, and year to year. When the price of the overall basket increases, that's known as inflation. If the price of the basket goes down, that's known as deflation.

In general, a low level of steady price increases is normal and can be a sign of a growing economy, increased productivity, and/or technological improvement. America's central bank, the Federal Reserve, uses monetary policy to target, among other goals, a long-run average of 2% inflation annually.

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What are the Causes of Inflation?

In America, where most prices are set by the free market forces of supply and demand, the causes of inflation can be grouped into two major buckets - those that cause demand to increase, thus raising prices, and those that cause supply to decrease, thus raising prices. One of you asked - is inflation just caused by changes in supply or demand, so the short answer is yes, in the aggregate overall economy.

Right now, there are five different drivers collectively causing higher inflation concerns:

• A recovering and growing economy
• Increased money supply
• Increased government spending
• Pandemic-related supply shortages
• All of which are contributing to expectations of increased inflation going forward

Each of these, as well as other potential causes, are explained in more detail below.

Demand-Pull Inflation

Demand-pull inflation occurs when overall, aggregate demand in the economy increases relative to supply. Think of this as the demand of all goods and services simultaneously increasing - so there is more quantity demanded at every price, pulling the demand curve to the right, and raising the overall price level.

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Demand-pull inflation has 6 primary causes:

1. A growing economy: during an economic recovery or period of rapid economic growth, consumer demand can grow faster than supply, resulting in higher prices.
2. Inflation expectations: the market's expectations of future inflation, can actually create inflation, but increasing demand today. If you think prices will be more in the future, you buy today. It creates a self-fulfilling prophecy
3. Increased money supply: if the government prints too much money, it can cause inflation, creating too many dollars in circulation chasing too few goods. It makes everyone's dollars worth less, increasing the price of goods. This is a current concern as the money supply, has increased more in the last year than ever in our nation's history.
4. Fiscal policy: government spending and tax policies can add to demand as well. It can be through the government spending directly on goods and services, like during war times, or through tax breaks or stimulus checks, putting more money in consumers' pockets for increased consumer spending.
5. Marketing: certain individual brands or products can demand higher prices because of strong branding or marketing. Think of Apple and the iPhone, or some more extreme examples, and I'm dating myself here - but anyone remember the Beanie Baby craze of the 1990s or the Cabbage Patch craze of the 1980s? Strong branding and marketing tactics, like "limited supply," drove price inflation for these items.
6. Technological innovation: remember how expensive the first flatscreen TVs were? Or how much Tesla wanted for the first edition of their electric sports cars? New technology can also demand higher prices until more competitors enter a market and compete prices down.

Cost-Push Inflation

Cost-push inflation occurs when supply is reduced due to increases in the cost of production. This could be due to higher wage costs or higher raw material costs. Higher costs of production can lead suppliers to reduce supply at every price point, shifting the supply curve to the left, increasing overall prices, and passing the increased cost of production onto consumers.

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There are 4 primary causes associated with cost-push inflation:

1. Natural disasters: unpredictable disasters, like hurricanes or a global pandemic, can cause inflation by disrupting supply, leading to supply shortages. We are experiencing these impacts now in raw materials, as well as production capacity in a variety of sectors.
2. Wage inflation: we haven't experienced wage inflation in many years as globalization has made wages more competitive globally. The unionization of labor in various industrial sectors did get wage increases for workers, which companies passed through to consumers.
3. Market structure: when an industry or market consolidates or there is a monopoly, it can give a producer pricing power that causes inflation. In the 1970s, OPEC (the Organization of Petroleum Exporting Countries) made up of 13-oil producing countries mostly in the Middle East and Central America, created significant cost-push inflation by restricting production and quadrupling the price of oil.
4. Government regulation: government subsidies and taxes can create inflation or deflation in various industries. Direct taxes on goods, like gas, cigarettes, and alcohol, intended to lower demand, instead just raise the price for the consumer. Government subsidies, which can lower production costs or shift production resources, can also impact prices. Current discussion of federal minimum wage increases or carbon taxes could lead to cost-push inflation.

How Do We Measure Inflation?

Now that we understand different ways price increases can happen, how do we actually measure higher inflation to know if it is happening? There are 2 primary data points economists look to as measures of inflation: the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Index (PCE).

Both the CPI and PCE are published monthly by the US Bureau of Labor Statistics and the US Bureau of Economic Analysis, respectively. Both represent a basket of goods and services, and we can compare how the price of that basket changes from month to month, and year to year, and the change in that price is the estimate for inflation. You can see that they track one another fairly closely. Core variations of these measures exclude food and energy prices, which can be more volatile from month to month.

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Prior to 2000, the Fed used CPI as their inflation measure. However, they have since shifted to using the PCE Price Index for three primary reasons:

• PCE reflects what people actually spend, with expenditure weights changing as people substitute away from some goods and services for others vs. CPI which is based on a fixed-weight basket of goods and services. This substitution effect has a tendency to make the PCE show slightly lower inflation over time vs. CPI
• PCE includes a more comprehensive basket of goods and services
• Historical PCE data can be revised over time to account for newly available information, or improvements in measurement techniques

The Fed, therefore, is essentially setting monetary policy with a goal towards a long-run average increase in the PCE Price Index of 2% annually.

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A third measure of inflation you may sometimes hear referenced, and more relavent for potential cost-push inflation, is the Producer Price Index (PPI). This reflects the cost of various raw materials producers pay in production. It is more volatile than CPI and PCE, as it is far more dependent on raw material and commodity prices.

Why Are People Worried About Higher Inflation Now?

Earlier I mentioned there are five different drivers collectively causing higher inflation concerns right now:

• A recovering and growing economy
• Increased money supply
• Increased government spending
• Pandemic-related supply shortages
• All of which are contributing to expectations of increased inflation going forward

We all know we are in the midst of a recession induced by the pandemic, and now are hopefully through the worst of it and entering into a period of economic recovery. Most economists predict 4-5%+ GDP growth this year against the weak 1H 2020 comparisons from last year. During periods of expansion, it is not uncommon to see inflation tick up.

In addition, higher inflation concerns are heightened more than usual for the reasons explained in more detail below.

Increased Money Supply

The central bank in the United States, the Federal Reserve, is led a by non-partisan Board of Governors and chaired by Jerome Powell. Powell has served as a member of the Board of Governors under both Democrat and Republican Presidents, was appointed Chair by President Trump in 2018, and serves a 4-year term.

The Federal Reserve is tasked with "promoting maximum employment, stable prices, and moderate long-term interest rates" through monetary policy, which includes setting short-term lending rates via the Federal funds rate and controlling the overall money supply.

During a recession, as we experienced in 2020, the Fed acts quickly to make monetary policy more accomodative to lessen the severity of the downturn. They reduced short-term lending rates to effectively zero, and begain increasing the money supply by using their balance sheet to purchase financial assets, like US treasury bonds and mortgage-backed securities on the open market. This puts more dollars into circulation.

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As we have begun to recover from the impacts of the pandemic in the 2H 2020 and into 2021, many continue to ask how long the Fed plans to continue their accomodative monetary policy, which has seen the money supply grow more rapidly in a single year than ever before.

In 2012, the Federal Reserve first announced a formal and public commitment to an inflation target of 2%. In August 2020, the Fed amended their statement on Long-Run Goals and Monetary Policy Strategy. One of these changes, since inflation has rarely met or exceeded 2% since their 2012 announcement, is that...

In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

Federal Reserve Statement on Longer-Run Goals and Monetary Policy Strategy, as amended August 27, 2020

This tweak in terminology on inflation specifically, as well as comments from Chair Powell emphasizing "that maximum employment is a broad and inclusive goal," not just the headline 4-4.5% unemployment rate they've historically targetted, lead many economists and investors to speculate that the Fed plans to allow inflation to run higher than 2% - higher than it has in recent history - in the forseeable future.

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Increased Government Spending

In addition to the substantial increase in the money supply over the last year, we have seen a dramatic increase in government spending as well.

To date, prior to the $1.9 trillion stimulus bill currently under consideration in the Senate even getting passed, the US Government has passed $3.5 trillion in government spending in response to the pandemic. This includes:

• $560 billion in expanded unemployment compensation
• $445 billion in direct stimulus payments

... for over $1 trillion in funds sent directly to US households. What we have seen to date is these payments, while boosting household incomes, have not fully boosted consumer spending, but instead, dramatically increased savings rates.

Why aren't we seeing this increase income translate to consumer spending? A few factors are at play here.

1. Supply shortages: as mentioned before, natural disasters, like a global pandemic, can cause supply shortages. Many of you have reported an inability to buy things or significant backorders on items like furniture, appliances, computers, and building supplies. There are also shortages of microchips, which have created production halts at major auto manufacturers as well. In some areas, production capacity is still constrained as well by health restrictions.
2. High unemployment: unemployment remains elevated and people remain cautious, with uncertainty about their future income prospects. They are saving more to guard themselves against future income losses.
3. Pandemic restrictions: while the government is sending out stimulus checks to stimulate spending, many of the areas that need consumer spending the most - like travel and restaurants - remain constrained in many states by health department restrictions.

Until the economy is fully re-opened AND consumers feel comfortable and confident resuming normal pre-pandemic activities, we are likely to see the savings rate remain elevated and consumer spending remain below the trendline, no matter how much stimulus the government pumps into households.

That being said, many households will be financially well-positioned for a significant increase in consumer spending - pent-up demand - when things open up. This is also adding to higher inflation expectations.

Signs of Higher Inflation

One of the drivers of demand-pull inflation is the expectation of higher inflation. When people think prices will be higher in the future, it becomes a bit of a self-fulfilling prophecy - as people increase demand today to avoid higher prices in the future.

The Fed argues that they make monetary policy on ACTUAL data points - not just expected ones. And while we may not see the CPI or PCE surpassing 2% yet, economists and investors are seeing signs of higher inflation supporting their expectations.

Interest Rates vs. Inflation

In general, when interest rates are low, more people borrow money, increasing the money supply and giving consumers more money to spend. This leads the economy to grow and inflation to increase. This is why the Fed lowers interest rates at the outset of a recession.

The opposite is true for rising interest rates. As interest rates rise, it becomes more expensive to borrow, and people are more likely to save to earn higher interest rates. This reduces consumer spending and the overall money supply, slowing the economy and inflation.

The Federal Reserve only sets the Federal funds rate - the overnight lending rate to banks - at the shortest maturity on the yield curve. The market determines all other interest rates on the curve.

When investors expect inflation to increase, they demand higher rates of interest for longer-dated maturities to offset inflation. This causes the yield curve to steepen. This is what we are seeing happen, very rapidly, in 2021, which is driving the heightened concerns for higher inflation.

The rates of 5-year US Treasuries have more than doubled (0.36% to 0.78%) since the start of the year, 10-Year Treasuries rates have increased by nearly 60% (0.92% to 1.46%), and 30-Year rates have increased by more than 30% (1.65% to 2.18%). Now, these all still remain low in absolute terms relative to history, but are a sharp increase in a short period of time, and relative to short-term rates, which is predictive of higher inflation in the future.

Leading Indicators of Inflation

Beyond the steepening yield curve, academics have published studies on predicting inflation. The most predictive indicator of higher inflation? The spread between 10-year US Treasuries and 10-Year TIPS, Treasury Inflation-Protected Security. TIPS are a Treasury bond indexed to inflation to protect investors from higher inflation. As inflation rises, the principal value of TIPS rises too.

The spread in the yield between a regular 10-Year Treasury Bond and a 10-Year TIPS bond is predictive of inflation, generally with about a quarter lead time, based on history. In February, the spread hit its highest level in more than 6-years, predicting 2% inflation, as measured by change in the PCE Price Index, within the next 3 months.

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The other major driving behind inflation concerns? The dramatic growth in the money supply. I've mentioned it before, but it's worth mentioning again - if nothing else than just to point out how dramatic the increase really is relative to history.

Why is Inflation Bad?

Now that we understand what inflation is and why everyone is talking about higher inflation at this moment, let me address why people are so worried about it.

A little bit of inflation can be good. It can be a sign of gains in productivity or technological innovations. It can be a sign the economy is expanding more rapidly. But too much inflation - especially inflation that exceeds income growth - can diminish not only purchasing power, but quality of life as well.

In simple terms, if prices rise by 3%, but your income doesn't change, you can only afford 97% of what your income bought you before. What will you eliminate? And this impact compounds, annually, giving you less and less purchasing power with every passing year.

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As you might assume, this far more impacts lower income earners than anyone else, for two reasons: 1) their income has grown more slowly, barely exceeding inflation and 2) they own fewer interest-yielding assets, which benefit most from inflation. This causes inflation to increase wealth inequality.

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Low Interest Rates, Stimulus Has Fueled Asset Prices

Just look at what has happened in the last year to asset prices over the last year in the face of rock-bottom interest rates and skyrocketing money supply...

• The stock market has gone through the roof, with valuation measures exceeding all rhyme or reason.

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• And low interest rates and supply shortage have driven home prices up the most since post-Great Recession too

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Who benefits from this the most? The ones who already own these assets, and it now becomes more expensive and harder for you to own assets if you don't.

How do You Protect Yourself from Higher Inflation?

So, if economists and the market all think higher inflation is coming, how can you guard your family finances against higher inflation and loss of purchasing power? The same way the rest of investors are - by owning assets that give you a yield, or rate of return, greater than inflation.

Money sitting in a savings account earning 0.5% a year is not enough to offset 2% predicted, annual inflation. You are losing 1.5% of the purchasing power, compounded annually. Currently, 30-year US treasury bonds are yielding over 2%. And the stock market, historically, has generated an annual return of 8-10%, including all the ups and downs along the way.

A balanced portfolio, investing consistently for the long-term, that grows your net worth over time, will help you generate income that exceeds inflation growth. Learn more about Investing in the Investing for Beginner Series here. Coming up next - diversification and building a balanced portfolio.

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I'll be keeping tabs on many of these metrics and indicators as part of the Monday Market Update, to keep all of you informed on where prices are going and when expected higher inflation starts to become more of a reality, not only in asset prices but official measures as well. What other questions do you have about inflation?

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