Inflation: what is it and why is it rising?

Photo source: Zac Porter, Unsplash

What is inflation?

Inflation is a persistent rise in the price of a basket of goods and services in an economy. This basket consists of necessities, like toothpaste, bread, rent, or electricity. When these prices rise, your money buys you less because you need more units of money to buy the same thing. Think how the price of a cup of coffee has changed over time (from $0.25 in 1975 to $1.50 in 2020). That’s why inflation corresponds with a loss of purchasing power for the currency that’s used in that economy, such as dollars or euros. A loss of purchasing power for necessary items means the average consumer feels the financial pinch, while wealthier consumers will feel the impact in their cash savings, or ability to splurge on discretionary items.

How does inflation work?

Inflation happens only when the overall prices of goods and services are persistently rising. If the price of a single, or a small handful of goods or services rises, such as oil or real estate, inflation in the truest sense is not present. This is why it is important to look at the aggregate prices, which are measured by the Consumer Price Index (CPI) of various economies. However, a single commodity’s price rise can have a material impact, as recent events show, so keeping an eye on every good and service price within that basket is critical to understanding potential imbalances in the economy.

In the current state of affairs, overall prices are rising and the consensus view is that persistent inflation is here to stay for a while. Looking at the two main causes of inflation explain why this is: demand-pull inflation and cost-push inflation.

Demand-pull: This is considered the most common type of inflation. It is the upward pressure on prices that follows a shortage in supply, a condition that economists describe as "too many dollars chasing too few goods."

Cost-push: Cost-push inflation (also known as wage-push inflation) occurs when overall prices increase (inflation) due to increases in the cost of wages and raw materials. Higher costs of production can decrease the aggregate supply (the amount of total production) in the economy. Since the demand for goods hasn't changed, the price increases from production are passed onto consumers creating cost-push inflation.

The pros and cons of inflation  

Inflation is not always a net negative occurrence. When consumers’ wages rise in line with rising prices, the economy grows and people’s lives tend to be more prosperous. Everyone is happy.

However, if wages grow, causing prices to grow, which in turn causes wages to grow again, and so forth, this is called a wage-price-spiral, which if left unchecked can lead to soaring inflation forcing monetary policymakers to “slam the breaks” by “hiking” interest rates to deflate the economy. Like they did in the 1970s when the oil crisis sparked high inflation and central bankers had no choice but to raise interest rates to such high levels that this induced a recession. Such volatility for consumers, businesses, policymakers, and indeed anyone, destroys confidence and inhibits an economy from progress.

This is why central banks set an inflation target of 2% annual price growth – this, they believe, is the “goldilocks” rate of inflation that enables economic progress and prosperity of the populace, without prices getting out of hand.

Why is inflation rising?

Until a few years ago, major economies struggled to achieve their 2% target in economies including the United States, the UK, and the eurozone. The coronavirus pandemic changed the world dramatically. One of the results was the uptick, and then escalation of inflation. But why?

Typically, inflation starts when demand outstrips supply (demand-pull inflation). This tends to happen alongside “loose” monetary policies. For example, when governments inject money into the economy to help it expand following a recession or a crisis. Following the global shutdown and halt to economic activity when COVID-19 hit, governments and central banks poured unprecedented amounts of monetary and fiscal stimulus into businesses and consumers’ pockets to cope with the impacts of the pandemic.

On the other hand, cost-push inflation is driven by wages or higher production costs. This may happen if a natural disaster reduces the oil supply, but demand stays the same even as supply shrinks. This scenario also happened during the pandemic, as the cost to keep factory workers safe and to simply deliver goods and services rose the production costs, which were passed on to consumers.

Inflation driven by both demand-pull and cost-push is rare, but it was clear that normal supply/demand dynamics were not at play during the pandemic. Indeed, supply and demand couldn’t even connect in many marketplaces. The world, and all the economic activity that goes with it, all but stood still, so the equilibrium of supply/demand dynamics snapped in half. Maker couldn’t meet market place.

People still wanted to travel, and airplanes and airlines could serve them but travel couldn’t happen. People wanted to buy cars, but raw materials couldn’t be mined and car parts couldn’t be manufactured without risking the health of employees, etc.

This marketplace disconnect drove a knife through the supply and demand curve, which resulted in a mismatch between the supply price and demand price of a good or service. The knife edge represents the cost of making trading safe and possible – when economies opened up again, consumers expected prices to be the same, but production and suppliers had to pay more to produce and deliver the same amount of goods and services as pre-pandemic levels. The higher cost consumers had to pay is a symptom of inflation.

By mid-2021, the double whammy of demand-pull and cost-push inflation was largely present in economies that were once again opening up. Then energy prices started to rise.

What caused the rise in energy prices?

Economic activity is strongly linked to energy. The pandemic shut off demand and disrupted supply chains, including or especially those in the energy sector. This was seen in the unprecedented negative prices of oil at the trough of the pandemic, and in the considerable spike in prices, as economic activity recovered worldwide.

Crucially, as the demand tap switched off in late February 2020, Russia and Saudi Arabia – the two most powerful members of OPEC+ - were locked in a supply war that flooded markets with surplus oil. There was so much oil there was nowhere to put it, and in mid-April 2020 the price of a barrel of West Texas crude went below $0 as sellers had to pay to to get rid of it. Many predicted peak oil, including the CEO of Shell in July 2020 after a sharp profit drop. All but writing his own company’s death warrant on the wall.

That summer of 2020, two things happened that set energy-led inflation on its current, steep path:

1. The European Commission’s Fit for 55

This was an ambitious set of reform proposals for the EU’s Emissions Trading System (ETS, Europe’s carbon emissions marketplace where you buy and sell emissions), which includes a recommendation to significantly strengthen the ETS and widen its scope, which currently covers only around 40% of the EU’s greenhouse gas emissions. The package also proposed to raise the taxes for dirty fuels, and lower them for clean ones.

2. The ongoing transformation in financial markets

2020 was a reflective year for financial markets. The inexorable suffering of people around the world, the deeply ingrained inter-dependencies of the global economy, the failure of vital infrastructure such as healthcare, especially in emerging markets, as well as the less tangible mindset shift of many as to what they deemed valuable – family, health, time outdoors, etc.

ESG funds outperformed the market in the first year of the pandemic. Market participants realised that such funds and companies that care about ESG express more resilience, and offer diversification in troubled times. Imagine a strong company culture that translates into staying power or a company whose products offer a better, cleaner alternative than a fuel-intensive market mainstay. The merits of ESG products, services, funds, and mentality are well documented and the pandemic acted as the first true test that sustainability is no longer a nice to have, but a must-have.

Many institutional investors have now started to materially reduce their exposures to fossil fuel energy producers and have redirected capital to more environmentally acceptable low-carbon alternatives. Ourselves included, as we explain in detail in our annual RI Report. European Central Bank (ECB) analysis showed that financial markets are increasingly serving as a “corrective” device to help shift the global economy on a better, more sustainable track. In short, these two developments are a net positive driver for the sustainable transition.

However, both also caused the price of carbon to rise due to investors and markets recognising the premium rewarded to investors for taking on the risk of an asset (carbon) whose writing was on the wall.

The levelized cost of green and renewable energy has been steadily lowering in recent years so that it is now much cheaper than fossil fuel energy. The reason why adoption has been slow has been the challenge of consistent and undisrupted access to renewable energy when the wind doesn’t blow or the sun doesn’t shine. The deficit has had to be filled by fossil fuels until we work out a solution to this challenge, which is taking time.

As oil and gas companies shut down and investment flows halted during the pandemic, especially as market participants declared peak oil, fossil fuels became more scarce. As economies opened up again, that scarcity combined with desirability, causing the premium in fossil fuel prices, which has led to soaring energy inflation. Given energy’s role in all aspects of the economy, there have been knock-on effects on overall prices of goods and services too.

Russia’s invasion of Ukraine and the consequent war have only served to aggravate and intensify these pre-existing, pandemic-driven conditions due to Russia’s role in the energy value system worldwide. With no end in sight, energy security is increasingly under threat, especially in Europe.

But it is not just high energy bills concerning experts. The impact of the war on food supplies and consequent rise in food prices to unaffordable levels for many citizens reliant on these commodities is becoming a grave concern.

As investors, we must understand these issues through our holistic lens and how they will impact markets. As will policymakers, who have an incredibly challenging road ahead to deal with so many conflicting concerns.

The challenge for governments and policymakers

Governments and policymakers have significant challenges ahead. Not only to continue dealing with the scars of the pandemic and slowing global growth, but also to navigate the current geopolitical turmoil, and inflationary environment, and to protect the vulnerable from the increasing potential for energy and food security issues.

All of which are interrelated, with first, second,, and third-order impacts at play within the broader context of a worldwide push to shift the economy to one that’s more sustainable, equitable, and green.

As they did with the pandemic crisis, we expect the Fed will not be afraid to slam the accelerator to reach its targets or slam the breaks if it overshoots them. In this way, central banks are a key source of liquidity in modern-day economics and so what they decide to do has an impact on returns.

At the same time, governments must also attempt to help consumers who will suffer from higher energy and food prices. Two recent proposals by the EU Commission go in the right direction:

1. One is the introduction of the Social Climate Fund, which aims to address the social impact of higher energy prices resulting from the proposed broadening of the scope of the ETS towards the building and transport sectors, both of which will affect households in particular.
2. The other is the proposed system for EU countries to jointly procure strategic reserves of gas that can be released in the event of supply shortages. At present, the capacity utilisation of gas storage facilities in Europe is just under two-thirds, almost 20% below seasonal norms. Energy buffers will help limit the volatility of gas prices.

How central banks and governments will navigate a “soft-landing” for the global economy, bringing inflation rates back down to target levels without destroying confidence, and so economic growth, or leaving vulnerable people at risk of energy and food poverty is the big question mark overshadowing financial markets currently.

It’s why, for example, in May we saw the mixed performance as the market judged which scenario was the most likely to occur – a stagflation scenario, a recession, or a goldilocks scenario (amongst others). Given the number of extenuating circumstances that have got us to this current regime shift, the number of outcomes from here are many – hence the unpredictability and volatility.

Next in this series, we’ll show you how we make sense of this complexity using our compass – our strategical asset allocation tools including our macroeconomic scenario framework, inflation clock, and other mental models. We’ll also explain how these tools can do only so much. As active investors, our human instincts, conscience, and skills are also important to ensure a safe and successful voyage.

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