Chapter 11
Inflation—Just a Little Bit

Inflation is a symptom, not the root cause of an illness. Various economic factors interact and then inflation can crop up and have a huge influence on interest and currency exchange rates, consumer spending, savings, and corporate profits. Inflation is also very similar to plumbing in an old house. If it starts to leak it is not always easy to tell where it is coming from or how to fix it. If you can not stop it, it may get out of control and cause significant damage. A country also does not want inflation to run too hot or too cold. Just like trying to adjust the temperature in a tricky shower—if it runs too hot you can get burned and if too cold, things shrivel up.

All investible countries have some measures of inflation and like all big numbers taken from multiple surveys they are both valuable and problematic. There are many different measures of prices and inflation. The one that has historically received the most attention is the consumer price index (CPI); almost every country has a version of it. In the United States the personal consumption expenditure deflator (PCE) and the producer price index (PPI) are also widely followed. Different countries have variations. In the United Kingdom. the retail price index (RPI) and its variations are popular; some versions include mortgage and interest payments. Also, in countries where there is value-added taxes (VAT), measures are adjusted for these taxes.

The most widely followed version of the CPI is the core consumer price index (core CPI). In most countries this type of inflation measures a basket of goods that the government believes represents a cross-section of regularly purchased items by the consumer and price changes are tracked. The reason it is considered “core” is that it takes out items related to energy and food. These segments are considered too volatile and can distort short-term trends. In the United States the Federal Reserve over the last few years has preferred the PCE as a tool for monitoring inflation. The PCE is considered to cover a broader set of goods and focuses on what is consumed by households rather than a basket of goods, like the CPI. The PPI is often viewed as a leading indicator for the CPI as it measures a fixed set of goods and services like the CPI, but the focus is on the cost of the output of United States based producers (so no imports). The PPI measures the cost of goods by the revenue received by producers rather than the amount spent as in most consumer-oriented inflation reports.

The rationale for using “core” is that these “commodity” items fluctuate too much and do not give a good picture of inflation’s near-term trends for the policy makers. However, food and energy are a huge factor in a person’s budget and frequently for companies as well. The cost of food, and especially, energy, transmit through the economy over time and show up in the core numbers, but their impact on spending habits has already been felt strongly by that time. As an example of the dangers of only focusing on core inflation, the 50% rise in energy prices in the United States in 2008 was a major contributor to the recession that followed but would not have been captured in the core number. Recognize that policy makers may use core inflation measures and it is often what the media talks about, but the full CPI is a vital reflection of how inflation is impacting the economy in the short term.

There are many theories on the causes of inflation, and when inflation occurs it is generally not just due to one factor:

Cost Push Inflation: This is usually associated with a rising cost of the inputs to production. This traditionally has included raw materials, like oil or cotton, and labor. When it is heavily related to the cost of labor it may be called “wage push inflation.” A major factor that can deflect this type of inflation is the ability to substitute cheaper or more efficient inputs into production. In some cases technology is lowering the cost of inputs or the amount of inputs needed. Logistics technology is decreasing the cost of developing lower cost inputs from alternative geographies.

Demand Pull Inflation: This is driven by increasing consumption, or by too small an amount of supply of a product. Either way, purchasers of products are buying more and willing to pay more so producers and retailers raise their prices. Sociology may be having some effect on this form of inflation, as the great recession has appeared to cause more cultural frugality making people more likely to defer purchases or find substitutes when prices move up. It is also easier today to find substitutes because of global supply chains and access of information about alternative products over the internet.

Money Supply: This is often linked with demand pull inflation. The theory focuses on a country putting too much money in circulation, which increases demand and drives prices up, in part because the value of the currency has declined due to its increased availability. Sometimes this has occurred in a country that has created a large debt burden and is using the increased money supply to help address it, instead of cutting expenditures or increasing taxes, the country effectively prints money.

Currency Devaluation: For many reasons currencies can become devalued (e.g., political instability, trade imbalances, gross domestic product [GDP] declines). When there is a significant devaluation in a country that is particularly dependent on imports it can result in a spike in inflation as imported goods cost more. If the country has a reasonable export economy its lower currency could help to sell more goods abroad.

Inflation Expectations: Interacting with all of these theories above is the population’s inflation expectation. When people’s expectations are more extreme it can be self-fulfilling. In other words, if people expect prices to go up by a significant amount they may buy more goods because they expect products to be more expensive causing demand pull inflation. Thus far millennials have not really seen a major inflation shock, as this age group gets older inflation expectations may be set in a very tight band and reactions to even a mild inflationary move could spiral.

A certain level of inflation is usually desired in an economy. Prices historically go up with an expanding economy, asset values increase and this helps to encourage economic activity. However, when it gets out of hand it erodes the value of a currency, reduces savings, and stretches consumers’ budgets, and especially hurts those on fixed incomes. It can create shortages of goods as the reduced value of the currency makes it more expensive to buy materials from overseas. Also, deflation is not good. It means the value of people’s wealth is declining. For example, the value of their home may be worth less each year. It also means they are seeing prices of goods going down each day, so if their expectations are for continuing deflation they will defer purchases, further hurting the economy as consumption drops. You can see that too much inflation or deflation are both particularly damaging to people on a fixed income and those that may have a significant amount of their net worth tied up in a hard asset like a house. So countries with an aging population have to be particularly sensitive to balancing inflation levels.

Economies seem to thrive when there is modest inflation and relative price stability. In the developed countries, and many lesser developed countries, the central bank’s primary mandate is to try to maintain price stability. It is typical to have a target rate of inflation in the low single digits. Central banks try to manage inflation through shifting short-term borrowing rates. Investors around the world and within each country may adjust their expectations for inflation in a given country depending how convinced they are that the central bank of that country has the tools and the fortitude to properly manage inflation.

Technological innovation has an impact on inflation in a multitude of ways. New technological products can have a deflationary pricing trend as they get adopted and this has had an impact on inflation, especially as technology adoption has accelerated. Some of this decline in the prices of technology products is due to scale, as a technology gets more widely accepted, some of the price decline is due to competition entering the market after a new technology is introduced and some is due to other efficiencies that are developed over time. As an example of technology pricing trends, in 1983 when the Motorola DynaTAC mobile phone was put on the commercial market it sold for approximately $3,995. By 1996 the Motorola Startec was introduced and it was selling for approximately $1,000.41 Mobile phone prices did not rise again until smartphones were introduced by Apple, and they do the job of multiple products (e.g., cameras, music players, planners, etc.). During the same time the average price of an automobile in the United States went from $10,607 to $18,525.42

Technology-driven improvements in logistics, efficiency, through energy savings, communication, and modern financing tools, has allowed companies to expand their supply chains to source the most cost-efficient supplies around the world. This has also had a major deflationary impact, but has introduced risks that can shock inflation. Shocks could come from a spike in transportation costs, civil unrest within the supply chain, or natural disasters far away from where the final product is sold.

Since the great recession many central banks have struggled to get inflation to their target rate, but the problem has generally been that inflation has been below the target rate, not above it. Many central bankers and investors continue to look at old models to factor in the drivers for inflation. It is not that factors, such as employment levels, do not matter anymore, they just do not matter as much as they once did, in part because of the impact of technology. While almost everything else in the world is moving faster, it may appear that inflation is moving slower. It is not necessarily slower, it is just that people can react much quicker to address the causes of inflation. While most people still look at traditional models of inflation, understanding the changes from technology in inflation can give you an advantage in picking investments. Inflation is increasingly likely to simply move in a narrower band. One of the dangers to the economy can be if regulators and policy makers do not acknowledge and adjust for the impact of technological changes.