7 minute read
To your clients, inflation is a big deal.
Many clients may want to know more about it since it directly impacts their quality of life and retirement plans.
And while the conventional wisdom is that inflation is essentially from money printing by the Federal Reserve – is that always the case?
Now, what if I told you there are actually three types of inflation?
That’s right. Three.
And each one matters when trying to understand price trends.
Even better, at the end of the article, I will show you how all three inflations spurred prices since the pandemic.
So, the next time a client says, “Inflation is only due to the Federal Reserve printing money,” you can hopefully provide insight and context to the conversation.
Now, let’s break these down. . .
The Three Types of Inflation Easily Explained
First, let’s go over the fundamentals of the three inflations.
1. Demand Pull Inflation – caused by increased buying relative to supply.
Or said another way, there’s more spending power (income) chasing a limited supply of goods – and this pushes prices up.
For example, in the Middle Ages, during times of peace, there would be fewer men dying in wars. Meanwhile, they’d marry younger and have more children. And on and on.
This increased the population and therefore led to an increase in prices because the supply of goods couldn’t keep up with more mouths to feed.
In fact, this is what led Thomas Robert Malthus – a leading English economist in the 18th century - to come up with the ‘Malthusian Trap1’; which essentially meant population growth directly influenced food prices, wages, and the standard of living.
Put simply, human history was generally stuck in a loop when population growth outpaced2 agricultural production, causing rising prices, famine, or war – thus resulting in poverty and depopulation.
Figure 1: The Malthusian catastrophe simplistically illustrated
According to some, the only way out of this multi-century-long trap was the beginning of the Industrial Revolution (early-1800s) which brought modern innovation to allow mass agricultural production. Thus, increasing supply faster than before - which kept prices from rising.
But the main takeaway here is that demand – all else being equal – can cause inflation on its own.
2. Cost-Push Inflation – caused by changes in supply relative to demand.
This type of inflation occurs when the supply side changes suddenly when demand is flat.
For instance, a major discovery of copper could lead to falling copper prices due to the increased supply. Or a sudden decline in oil output – like after the Russia-Ukraine invasion in 2022 – could send oil and gasoline prices soaring.
Imagine the demand for apples growing 1% a year. But then suddenly there’s a massive orchard failure from bad weather and apple output sinks 50%.
Thus, prices for apples would likely increase sharply amid the declining supply.
This is important because even without increased demand, prices can still rise from changes in supply (remember, it’s called demand and supply).
For those interested in charts, here’s a good technical one showing3 how cost-push inflation works (AS stands for aggregate supply; aka total output).
Thus, the main takeaway here is that by cutting the output, prices generally rise.
3. Monetary Inflation – the sustained increase in the money supply.
This is the most volatile form of the three inflations as it can amplify demand through increased purchasing power (putting more money in people’s hands). Or lead to changes in supply as more money chases new supply sources (more money flowing into marginal investments).
But, generally speaking, increasing the money supply does increase prices only as long as people keep spending.
Now, there’s a popular misinterpretation that the Federal Reserve “prints” money. But that’s not exactly right.
Because the Fed technically doesn’t print anything. However, they can influence inflation by tinkering with bank reserves.
· Bank reserves are the cash minimums that financial institutions must have on hand to meet central bank requirements. This is real paper money that must be kept by the bank in a vault on-site or held in its account at the central bank.
· For example, if a financial institution holds $1,000,000 in deposits and the reserve ratio is set at 10%, then the minimum cash reserve the financial institution needs to maintain is $100,000 ($1,000,000 times 10%).
Put simply, the Fed can pump money into banks, increasing bank reserves available, and thus influencing them to lend more (or vice versa).
How does this work?
In short, when the central bank (let’s say the Fed) engages in quantitative easing (QE), they’re essentially buying assets from banks – such as U.S. treasuries – and giving them reserves instead.
Then, these banks who are now sitting on more reserves would feel influenced to lend more (aka turn the reserves into yielding loans).
Now – quantitative tightening (QT) – is the opposite.
It’s when the Fed sells its bonds and assets to banks (taking away their reserves in return). Which then influences banks to curtail new lending as their reserves have declined. Which saps money out of the system and may push prices lower (i.e. less money chasing more goods).
This may be too technical, but the gist is that monetary inflation is the most volatile of the three and can amplify price rises or declines.
The COVID Trifecta
Since the pandemic years in early 2020, prices have surged.
To put it into context – the CPI (consumer price index – an inflation measure) for all urban consumers (U.S city average) has risen 19% since January 2020.
Meanwhile, home prices to median household income (aka pre-tax annual income of two or more people) have soared to an 80-year high of 7.40x4.
This implies that it now takes 7.4 years of all pre-tax median income to buy a home outright.
These are just two examples of the sharp price increases that have affected many around the country.
But how did we get here?
Here's the backdrop: when the COVID pandemic struck in March 2020, the world watched as global policymakers endeavored to mitigate potential repercussions.
Yet, their strategies had a resoundingly inflationary impact when we look at it through the three types of inflations.
1. Cost Push Inflation – when global supply chains grounded to a halt as economies worldwide shut down, resulting in a collapse in the outflow of goods.
2. Demand Pull Inflation - when U.S. government injected a substantial amount of liquidity into the system. Measures such as student-loan deferments, mortgage forbearance, PPP loans, direct stimulus checks, tax credits, and the like, augmented purchasing power, thereby artificially increasing demand as spending capacity soared.
3. Monetary Inflation - when the Fed embarked on an aggressive easing course. They implemented measures such as zeroing out interest rates, infusing reserves into banks through quantitative easing (QE), indirectly purchasing corporate bonds, and acquiring over $2 trillion in mortgage-backed securities (MBS), among others. These policies maintained loose credit conditions and artificially buoyed asset prices, especially in the real estate sector.
At that point, the Fed was pouring gasoline onto a fire. . .
Consequently, between 2020 and 2022, these three elements—supply-side, demand-side, and monetary—simultaneously fueled inflation.
And – unfortunately – this is something the U.S. economy is still dealing with as of writing.
Conclusion
This article has delved into the existence of three distinct types of inflation – demand-pull, cost-push, and monetary inflation.
Each plays a pivotal role in understanding price trends, and all three have contributed to the price increases observed since the onset of the pandemic.
These are important things for your client to learn about because - as I highlighted above - there’s more to inflation than simply the “Fed printing money.”
Whether it’s housing, energy, or food – different supply, demand, and monetary factors affect prices in their own ways.
Thus, this knowledge equips financial advisors to offer potential insights to their clients and engage in meaningful discussions about the complex forces driving inflation.
Sources
1. https://en.wikipedia.org/wiki/Malthusianism
2. https://www.nextias.com/current-affairs/28-09-2022/the-malthusian-trap/
3. https://www.investopedia.com/articles/05/012005.asp
4. https://www.longtermtrends.net/home-price-median-annual-income-ratio/
Disclosure
This communication is general in nature and provided for educational and informational purposes only. It should not be considered or relied upon as legal, tax, or investment advice or an investment recommendation, or as a substitute for legal counsel. Any investment products or services named herein are for illustrative purposes only and should not be considered an offer to buy or sell, or an investment recommendation for, any specific security, strategy, or investment product or service. Always consult a qualified professional or your own independent financial professional for personalized advice or investment recommendations tailored to your specific goals, individual situation, and risk tolerance.
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