Inflation has become a very disturbing trend these days. The Consumer Price Index or CPI, which measures the rate of increase for a predetermined basket of goods, has soared to a level not seen since March 1982. Back then, inflation was subsiding. Today, it seems to be heading higher. The central issue is the inflation rate for producers, which is quite a bit higher than the rate for consumers.
Consumer Price Index (CPI)
Inflation is measured by the Consumer Price Index. Some suggest it is understated and that the rate is actually much higher. But that’s a debate for another time. At issue is how much it is rising and why.
Over the past 12 months, ending November 2021, CPI increased 6.81%. This recent spike has caused concern in the financial markets, more specifically the stock market, as it prompts the Fed to abandon its easy monetary policy and begin to tighten. In fact, the Fed has already announced it will withdraw its monetary stimulus faster than expected. This has made investors nervous, sending stock prices lower. Why is inflation rising so much?
Producer Price Index (PPI)
The Producer Price Index measures the rate of inflation for producers. Normally, PPI is below CPI. In fact, over the past 10 years, CPI has been higher than PPI 60% of the time. Even when PPI rose at a faster rate than CPI, the difference was minimal. This is not the case today as PPI (orange line) is much higher than CPI (see chart below). In short, production costs are rising at a much faster rate than consumer prices.
To explain, when producers are forced to pay more to produce their goods, as they are now, they have two choices. They can absorb the additional costs, which reduces profits; or pass these additional costs on to consumers. Since corporate profits are the lifeblood of stock prices, the more likely course is to pass these additional costs along to the consumer, which pushes inflation higher.
Supply Chain Woes
The supply chain issue lies at the heart of the recent rise in the cost of living. Because the world is dealing with a global pandemic, many countries have sporadically shut down portions of their economy. Even when economies are fully open, there is often a shortage of workers, which leads to a shortage of products. Even if there were enough products, there are significant bottlenecks at U.S. ports where products are stuck either on ships in the harbor or in storage containers at the port waiting to be unloaded and distributed. When you combine a shortage of products with strong consumer demand, you get a perfect recipe for a significant supply/demand curve imbalance. This is precisely why inflation is surging. Too much demand, too little supply.
How Long Will Inflation Remain Elevated?
Is inflation just a temporary problem? It depends on your definition of temporary. How long it lasts will depend on several factors. The first is how well the world controls COVID, which is expected to be endemic like the seasonal flu. Inflation will subside as we return to normal. How will this occur? Effective treatments, responsible government policies, and a cooperative society. It also depends on how the rest of the world handles the pandemic. During the past two years we have learned just how interconnected we are to the rest of the world.
Inflation will also subside if the economy weakens. What could cause this? The short answer is Fed policy. As the Fed continues to withdraw its monetary stimulus and sets its sights on raising interest rates, the economy will weaken. Too much Fed tightening, historically, has been a catalyst for recessions. Demand falls during a recession, which would help bring the supply/demand curve back into balance.
In summary, inflation will be with us for a while, and possibly get worse before it gets better. Too little supply, too much demand, and a global pandemic causing supply chain disruptions are the relevant factors. Getting back to normal will also depend on how well the world handles COVID. And that, unfortunately, is unknowable.