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While most people are aware of inflation and how it can cause a surge in prices for everyday goods such as food, cars, and houses, many don't have a clear understanding of what causes inflation and how it can impact our daily lives. In this article, we'll take a closer look at the topic of inflation, exploring its underlying mechanisms and how to potentially preserve our wealth in a high inflation environment.

Content overview:

• Why is it important to understand inflation?

• What are the possible causes of inflation?

• What are the indicators used to measure inflation?

• What does inflation mean for the financial market?

• Summary

An economic cycle generally consists of four stages: Expansion, peak, contraction, trough.

Throughout this cycle, inflation often plays a critical role as a catalyst for change. The chart below provides a clear illustration: as the economy transitions from recovery to overheating, inflation tends to rise. Conversely, when the economy begins to decline, deflation may become a factor.

From an investment perspective, it's important to understand and analyze inflation and how it can impact your financial goals.

For example, if an economy experiences persistent high inflation, it can quickly erode your purchasing power and make it difficult to cover your living expenses.

Imagine you are retired and have a million dollars in savings with annual expenses of about $100,000. You might think you could live off those savings for ten years or more.

However, if inflation during that time period remains at the elevated level of 5% per year, that same $1,000,000 will only cover your living expenses for around 7 years, meaning you may run out of money sooner than anticipated.

This scenario highlights the importance of identifying and understanding inflation as a key aspect of managing your asset portfolios and mitigating financial risks.

When inflation indicators are released each month, the Fed's monetary policy may change, and financial markets are likely to react accordingly. These changes may have significant impacts on corporate and consumer spending patterns.

Having a better understanding of the causes of inflation is the first step to analyzing it. At its core, inflation generally occurs when there is an increase in the money supply, which is controlled by the Federal Reserve through its monetary policies.

There are typically three types of inflation:

• Demand-pull inflation: The Fed controls the money supply by buying or selling government bonds and adjusting reserve requirements. An increase in the money supply gives people more purchasing power, which may lead to higher prices for goods and services.

• Cost-push inflation: When the cost of producing goods and services increases, companies often raise prices, resulting in supply-side inflation. For example, in 2021, the global chip shortage led to a surge in prices for intermediate products.

• Built-in inflation: This type of inflation stems from expectations. Workers may demand higher wages when they anticipate price increases for goods and services in the future. This can lead to a wage-price spiral, where companies raise prices in response to increased labor costs.

As both a driving force behind inflation and a critical decision-maker in controlling inflation expectations through its monetary policies, the Federal Reserve plays a crucial role in managing the impacts of inflation on the economy.

One of the primary objectives of the Federal Reserve is to maintain price stability, which it aims to achieve by setting a benchmark inflation rate of 2%. If inflation rises significantly above this level, the Fed often raises interest rates to attempt to bring it back under control. Conversely, during economic downturns, the Federal Reserve may print more money to try to stimulate economic growth.

Now that we know what can cause inflation, the question becomes: how can we determine its potential impact?

To answer this, let's explore three commonly used indicators in the market.

1. Consumer Price Index (CPI)

The CPI is the most commonly used inflation indicator, which measures the price index of a basket of consumer goods and services.

The CPI is defined by the "basket" of popular goods that consumers typically purchase, which includes eight categories: food and beverages, housing, transportation, clothing, medical care, recreation, education and communication, and other goods and services. When calculating the CPI, each category is assigned a different weight.

The U.S. Bureau of Labor Statistics (BLS) publishes CPI data every month, usually in the second or third week of the month. The CPI sample selection covers approximately 6,000 housing units and about 23,000 retail establishments such as department stores, supermarkets, hospitals, gas stations, etc., in 75 metropolitan areas across the country. They collect prices for around 80,000 items included in the "basket."

So how do we interpret CPI data?

When interpreting CPI data, we typically look at the year-over-year change, which indicates how much inflation has increased compared to the previous year.

If the CPI shows a significant increase, consumers may need to decide whether to pay extra money for their purchases to get what they want or cut back on spending.

An effective method for interpreting CPI data is to examine changes in individual components. This allows us to identify which specific items caused the CPI to rise during a given month.

For example, the graph below shows changes in CPI data since 2019. We can clearly see that the CPI spiked in 2021 due to rising energy (green bars) and commodity prices (black bars), reaching its highest level in 40 years in June 2022. As mentioned earlier, this type of inflation falls under the category of "cost-push inflation."

One of the solutions to address cost-push inflation is to strengthen production and increase supply. With increasing oil production and the Fed raising interest rates, both of which seem to help alleviate inflationary pressures, overall inflation in the United States has significantly decreased.

When analyzing the CPI indicator, we can review trends in the index over the past few years to determine if individual components have been subject to cyclical patterns or other factors. We can then combine our findings with market expectations regarding inflation trends to assist in making investment decisions.

What is the difference between Core CPI and CPI?

As we can observe, energy and food prices fluctuated a lot in the CPI subcategories. If monetary authorities focus solely on the CPI indicator, they'll have to make frequent adjustments to interest rates.

To address that, they created the core CPI, which is an index formed by excluding energy and food prices from the CPI. As shown in the graph below, the trend of core CPI is smoother than that of the CPI indicator.

BLS releases the CPI data on a monthly basis, including both year-over-year and month-to-month changes, as well as the Core CPI index. Investors can observe inflation trends by examining these three dimensions together.

2. Personal Consumption Expenditures (PCE) Price Index

Personal consumption expenditures (PCE) are reported monthly by the Bureau of Economic Analysis (BEA) during the fourth week of each month. PCE measures Americans' spending on goods and services, accounting for approximately two-thirds of the GDP, making it a major engine driving US economic growth.

The PCE report includes the PCE price index (PCEPI), another closely-monitored inflation indicator by both the market and the Fed. Compared to CPI, the PCE price index is favored by the Fed since it covers a wider range of expenditures and better reflects the actual inflation experienced by US residents.

This is because the PCE price index changes the weighting of consumer spending every month, reflecting how buying patterns change with relative price changes.

For instance, if the price of beef rises, consumers may opt to reduce their purchases of beef and increase their purchases of chicken instead. The PCE price index will also adjust the weightings of consumer spending to reflect how their buying patterns have changed in response to relative price changes.

Though PCE has its unique advantages, when measuring the actual inflation, both indicators are important. CPI data was released earlier and has a highly convergent historical trend with PCE, making it a leading indicator of the PCE price index. Additionally, as CPI has international comparability, it can be used for cross-country comparisons, making it a useful tool for analyzing inflation trends beyond the United States.

3. Producer Price Index (PPI)

Many people are familiar with the Producer Price Index (PPI) as it is also released monthly by the US Bureau of Labor Statistics, usually one day after the CPI data release.

The PPI measures the average price change over time that producers receive for their goods and services, serving as an indicator of how inflation is viewed by industry and commerce.

As the name suggests, the PPI corresponds to the perspective of "producers" compared to "consumers". The PPI measures prices based on initial output sales of products or services while CPI focuses on final sales. Since production occurs upstream from consumption, when producers face rising costs, they often pass them on to retailers and ultimately to consumers. Therefore, PPI data is considered a leading indicator of CPI data, and the market sometimes uses PPI data to forecast inflation trends.

How to track economic indicators in a timely manner?

Finally, let's touch upon the last topic of our discussion today: What does inflation mean for the financial market?

1. Commodities

When we think of the recent inflation surge in 2021, the first thing that comes to mind perhaps is the spike in commodity prices. Copper, crude oil, lumber, soybeans, and several other commodities have bounced back from their pandemic lows to reach multi-year or even record highs. As commodities account for nearly 40% of CPI, it's evident that their prices can significantly impact CPI data.

Gold, another critical type of commodity, is generally viewed as a hedge against inflation since it is priced in US dollars. When inflation lowers the value of the dollar, the price of gold tends to rise. It's worth noting that the prerequisite for gold's hedging properties is the "weakening of the US dollar." In 2022, gold generally did not perform well due to the strengthening of the US dollar.

2. Interest rates

As mentioned earlier, one of the Fed's primary responsibilities is to monitor and attempt to control inflation. Therefore, the Fed usually chooses to increase the federal funds and reserve interest rates, effectively raising the level of risk-free reserves in the financial system and limiting the money supply available for purchasing higher-risk assets. Rising interest rates will usually cool inflation as part of the Fed's tightening monetary policy. Conversely, when inflation is down significantly, and economic growth is slowing, the central bank may lower interest rates to stimulate the economy.

3. Stock market

In short, the rise in commodity prices caused by inflation usually increases companies' nominal income, often leading to an increase in stock prices. Although high inflation might also increase a company's operating costs and expenses, businesses can often pass these costs on to consumers through higher prices, so most of the time they do not significantly affect their profit margins. Industries that produce essential goods may have greater pricing power than others, such as food and energy. Therefore, we may see some companies' stocks soar during times of high inflation.

4. Investors

Some investors may find that their "safe investment portfolios" perform poorly during periods of high inflation. This is because 'overly stable but low-yielding assets' cannot keep up with inflation, which erodes the long-term value and returns of these assets. Therefore, understanding inflation is a good first step in protecting your wealth.

Summary

Here are the takeaways from today's discussion about inflation:

• Inflation tends to increase as the economy heats up and decreases as it slows down. Therefore, understanding the stage we are currently in within the economic cycle is very important for analyzing inflation.

• A fundamental cause of inflation is an increase in the money supply. The Fed serves as both a driving force behind inflation and a critical decision-maker in managing inflation expectations through its monetary policies.

• The indicators used to measure inflation include CPI, PCE price index, and PPI. Investors can analyze the main factors that drive CPI up or down by examining its subcomponents. The Fed prefers to use the PCE price index over CPI. Many analysts also use the PPI to predict inflation because it leads the CPI.

• Inflation is closely related to financial markets. Commodity prices can have a significant impact on CPI due to their high weightage in the index. The Fed can potentially cool the economy down by raising interest rates. Certain listed companies tend to benefit from higher inflation because it increases their nominal income, potentially boosting their stock prices. Therefore, understanding inflation might help investors protect their wealth.

Want to learn more?

If you now feel more confident in analyzing inflation after this lesson, consider checking out our "advanced" section of macro analysis! Keep up with the latest data, which might assist you in interpreting market trends and staying ahead of the game!