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Rising inflation is the topic du jour amongst CEOs, Wall Street analysts, and news publications. If you’ve seen recent headlines warning of higher inflation and are wondering how it impacts you or your business, you are not alone.

It isn’t surprising that many Americans don’t fully understand inflation and its consequences. If you were born and raised in the U.S. and are under the age of 40, then you’ve likely never had to think about it. That’s because the U.S. has enjoyed low and stable inflation of 2-3% since the early 1980s.

However, things may be beginning to change. The most recent April 2021 inflation reading was 4.2%, representing the largest annual increase since 2008.[1] And some are forecasting even higher inflation given the enormous spending bills passed by Congress – including the $2.2 trillion CARES Act passed in March 2020, the $1.9 trillion Coronavirus Relief Package passed in March 2021, and discussions of another potential $2 trillion infrastructure bill in 2021.

This article will help clarify what inflation is and how its measured, discuss some of its causes, and consider some of its potential consequences for consumers and businesses.

What is inflation?

Inflation is the sustained general increase in the price of goods and services in an economy. It affects everything from the cost of groceries to the cost of gasoline. If the price of a gallon of gasoline increases 10% from $2.90 per gallon to $3.19 per gallon, simply put, that is inflation.

In the U.S., the Federal Reserve is congressionally mandated to maintain price stability and has a stated average long-term annual inflation goal of 2.0%.[2]

A 2.0% inflation goal is based upon widespread agreement by economists that an environment of low and stable inflation is essential for a well-functioning economy.[3]

How is inflation measured?

Inflation is commonly measured via the Consumer Price Index (CPI) which is released monthly by the Department of Labor. The CPI attempts to measure the annualized change in the price of a “basket of goods and services” over time.

Items included in the basket are meant as a proxy for the cost of living and include basic items such as transportation, food, rent, clothes, medical expenses, and recreational activities. Economists distinguish between “headline inflation” and “core inflation.” The primary difference is that core inflation excludes food and energy in the basket of goods.

In April 2021, headline CPI increased 4.2%, indicating that a basket of goods and services in April 2021 cost 4.2% more than the same basket of goods and services a year earlier.[4]

Source: U.S. Department of Labor, May 12, 2021

Another widely used measure of inflation is the Producer Price Index (PPI). Similar to CPI, PPI measures the change in a basket of goods and services. However, PPI focuses on the prices of goods and services paid by producers as inputs to their operations or as capital investments, as opposed to goods and services purchased by consumers. Thus, PPI is more widely used as a measure of inflation in the business community.

In April 2021, PPI increased 6.2%, representing the largest increase since the Department of Labor began tracking the data in 2010.[5]

What are some of the factors that contribute to increased inflation?

Economists distinguish between two primary causes of inflation: demand-pull inflation and cost-push inflation.

Demand-Pull Inflation

Demand-pull inflation occurs when the demand for goods and services in an economy rises more rapidly than an economy’s productive capacity or supply. Demand-pull is the most common source of inflation and generally results from an increase in demand in response to the increase in the supply of money in an economy.

In the U.S., the Federal Reserve can indirectly increase the amount of money in circulation via open market operations (e.g., buying and selling of bonds and other securities). An increased supply of money tends to lower interest rates, which in turn spurs investments. It also puts more money in the hands of consumers, making them feel wealthier, and thus stimulating more spending (i.e., demand for goods and services).[6]

This is what happened recently in the U.S.

In response to the coronavirus crisis, the Federal Reserve instituted several unprecedented policy measures to limit the economic damage from the pandemic, including providing up to $2.3 trillion in lending to support households, employers, financial markets, and state and local governments.[7]

This caused the supply of money in the U.S., as measured by M2 (the broadest measure of the quantity of money in the economy), to swell to record highs. To put the increase in perspective, from 2010 to 2019 the M2 increased by an average of 6% a year. In 2020, the M2 increased $4 trillion or 26%, representing the largest annual percentage increase since 1943.[8]

Cost-Push Inflation

Cost-push inflation, considered more temporary than other sorts of inflation, occurs when the cost of production and raw materials inputs (i.e., the cost of supply) increases. This may occur in response to short-term supply shocks.

Recent examples of this include the blockage of the Suez Canal by an ocean carrier which caused a shortage in the supply of ocean carrier vessels and containers and thus an increase in the price of ocean carrier and container freight rates.[9]

Another recent example was the ransomware attack of Colonial Pipeline which caused a temporary closure of the largest U.S. fuel pipeline supplier and the price of gasoline to increase.[10]

Charts 1 and 2 provide illustrations of demand-pull and cost-push inflation as depicted by traditional economic supply and demand illustrations.

Source: Federal Reserve Bank of San Francisco, October 2002

Is inflation good or bad? What are its potential consequences on individuals and businesses?

Inflation can be good or bad. It largely depends on how fast price levels rise relative to other factors, and your perspective – inflation impacts different people differently.

Low and Stable Inflation Is Good

It is widely accepted by economists that an environment of low and stable inflation is essential for a well-functioning economy and thus a good thing. The Federal Reserve defines this as annual inflation of 2.0%.

The main thought here is two-fold. The first is to set expectations about future inflation, which ultimately impacts people’s behavior. A person may not buy a house, or a business may not invest in a piece of equipment, depending on their expectations of inflation.[11] The other goal is to avoid deflation. Economists aim to avoid deflation at all costs. In a deflationary environment, prices consistently fall, and consumers and businesses defer purchases and investments, which leads to economic contraction. Because inflation can be difficult to measure exactly, targeting a rate slightly above zero avoids inadvertent deflation.[12]

The Inflation Tax

When inflation rises faster than 2.0% the economic consequences can be significant.

One of the most influential economists of the 20th century, John Maynard Keynes, was very concerned with the negative consequences of inflation and likened inflation to an implicit taxation on the holders of cash.[13]

Keynes pointed out that rising inflation will erode the purchasing power of cash to the extent the rate of return on cash is less than the rate of inflation. For example, if prices increase 10% in a year, to avoid a negative return or an erosion of purchasing power, an individual would need to earn at least a 10% rate of return on their money.

Over time, Keynes argued that inflation can destroy the confidence in the value of money, disincentive savings and investment in new ideas, technology, and capital, and ultimately lead to economic contraction and a lower standard of living.[14]

Short Term Profit Increases

In the short run, businesses may benefit from an increase in inflation.

Famous investor Warren Buffett argues in his 1981 shareholder letter that for businesses to benefit from inflation, they must have two characteristics:

“(1) an ability to increases prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume, and (2) an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment in capital.”[15]

Unpacking this a little, Buffett is pointing out that good businesses have pricing power to increase prices faster than costs increase, and require low amounts of capital and thus do not feel the increase in costs as acutely as more capital-intensive businesses that must continuously invest in receivables, inventory, and equipment to maintain.

Lesser businesses can also experience short-term increases in profits because employee wages and other costs like long-term lease agreements tend to lag behind rising prices during inflation. For example, employee salaries are customarily reviewed annually and thus fixed in a given year.[16]

Other Consequences

Inflation acts as a double-edged sword with respect to debt, depending on your perspective.

Most retirees and even many near retires have a significant portion of their savings invested in fixed income (i.e., bonds). To the extent interest rates on these bonds are lower than inflation, one will experience an erosion of their purchasing power.

On the other hand, inflation can benefit debtors. When an individual or business borrows money, the cash they receive now is paid back with cash in the future. As inflation causes the value of money to erode over time, a borrower benefits from the ability to pay back the original debt with money that is worth less than initially borrowed.[17]

Summary

The unprecedented actions of the U.S. Congress and the Federal Reserve to limit the economic damage of the pandemic has caused the supply of money to increase at the fastest pace since 1943 and has recently led to the highest inflation readings experienced in the U.S. in more than 10 years. The U.S. has experienced three major periods of inflation since 1914, and each has been accompanied by a significant increase in the money supply: 1914–20, 1939–48, and 1967–80.[18] Despite this, there remains considerable disagreement about whether the current monetary and fiscal policies of the Federal Reserve and Congress will lead to persistent inflation above the Federal Reserve’s target of 2.0%. For now, the Treasury bond market for inflation-protected securities (TIPs) indicates that the market is expecting inflation to average 2.3% over the next 5 years. However, if Mark Twain was right – that “history never repeats itself but it rhymes” – it doesn’t seem unreasonable to expect that 2021 might make for the fourth major period of inflation in the U.S.

Sources:

[1] https://www.bls.gov/news.release/pdf/cpi.pdf

[2]https://www.dallasfed.org/research/economics/2021/0406#:~:text=The%20FOMC%20issued%20its%20first,personal%20consumption%20expenditures%20(PCE)

[3] https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm

[4] https://www.bls.gov/news.release/pdf/cpi.pdf

[5] https://www.cnbc.com/2021/05/13/producer-prices-april-2021.html

[6] https://www.econlib.org/library/Enc/MoneySupply.html

[7] https://www.brookings.edu/research/fed-response-to-covid19/

[8] https://www.wsj.com/articles/the-money-boom-is-already-here-11613944730

[9] https://theloadstar.com/shipping-rates-to-soar-with-a-new-cape-surcharge-as-ships-are-diverted/

[10] https://www.wsj.com/articles/u-s-gas-prices-hit-3-a-gallon-as-shortage-sets-in-amid-colonial-pipeline-shutdown-11620832180

[11] https://www.clevelandfed.org/en/newsroom-and-events/cleveland-fed-digest/ask-the-expert/ate-20190528-rich.aspx