How Does Inflation Work And What Causes It?

If you’ve bought anything recently, you know it costs a little more than it did just a year ago. The effect is widespread; groceries, gas, housing and numerous services are all more expensive. You’ve probably heard over and over again that this is caused by inflation and you certainly see the impact on your wallet. But how does inflation work? Let’s do a deep dive.

Economists define inflation as the rising cost of goods and services across the economy. This has the impact of decreasing purchasing power for consumers. If an apple cost a dollar last month and today is $1.25, your money isn’t going as far as it used to.

Over time, periods of sustained high inflation can have a detrimental impact on the cost of living. If there are dramatic and long-term price increases, people are unable to maintain the same lifestyle without spending more. This can in turn cause a push for higher salaries. The problem with this is it can have the impact of locking in inflation, but more on that later.

The opposite of inflation is deflation. This is when the price of goods and services fall. This isn’t good either. If you think computer prices will drop soon, you’re not as likely to buy one today. If enough consumers have this expectation across enough areas of the economy, businesses start to lay people off because they won’t produce goods and services if no one is buying.

The Federal Reserve (Fed) is the central bank and chief monetary policy setter for the United States. The two goals set for it by Congress are to maintain stable prices and maximize employment. As such, the Fed wants some inflation because that means people will buy today rather than waiting, keeping people employed. The trick is not to have so much that it erodes earnings.

When inflation is talked about, there are often three main types that are discussed: cost-push inflation, demand-pull inflation and built-in inflation. Although the result of these might be the same, the causes that contribute to rising prices are different. Let’s discuss each of these in a little more depth.

Cost-Push Inflation

Cost-push inflation is when the price of something goes up without a growth in the demand for the good or service. In other words, the price increase doesn’t have to do with matching up supply and demand. Some other event has caused prices to rise. Here are some examples of cost-push inflation.

• Monopolies: If there’s only one company producing widgets, they can charge whatever they want for the widget without fear of competition. In this situation, the company will charge as much as a consumer will tolerate. There are legal monopolies where you want a baseline level of service (think utility companies), but they’re government regulated.
• Wage increases: Companies periodically have to evaluate what they pay their employees to remain competitive for talent. In a healthy economy, the baseline is usually that the raise should be consistent with the level of inflation, but other forces can have impact. If a competitor starts paying more, companies may race to keep up, causing increased prices.
• Decreased natural resources: If there’s less of something and demand isn’t changing, prices are going to go up. A good example of this is oil. Over time, a price increase is likely to happen just because we can’t make more of it. Of course, there are also seasonal fluctuations and supply chain issues that can cause price fluctuations, so demand does play a role in pricing as well, but it’s cost-push susceptible in that you can’t just make more of it.
• Increased taxes: if the tax rate goes up, you have to charge more in order to maintain the same level of profit margin.
• Increased government oversight: There’s a cost to compliance. With oversight comes additional paperwork, people to check the paperwork and increased legal costs.
• Exchange rates: When prices increase, not everyone is impacted equally on a global level. The United States has a stronger dollar right now than Canada. As of this writing, $1 in the U.S. was worth about $1.30 Canadian. That means Canadian consumers pay more for U.S. imports and we pay less for goods and services from Canada.

The primary issue with cost-push inflation is that it’s fairly permanent. Companies have a very hard time decreasing wages once they’ve gone up, for example.

Demand-Pull Inflation

Demand-pull inflation is when inflation rises because there’s more demand for the products and services being produced. This makes more sense intuitively than cost-push inflation. If there’s more demand and the same level of supply, prices rise to find the balance again. Several factors can cause this type of pricing increase:

• Economic growth: Economic growth means prosperity. Prosperity means people having more resources. When people have more to spend, they’ll spend it, causing increased demand for goods and services.
• Expected inflation: This is when people thinking there will be more inflation in the future can actually lead to the inflation. If you think that prices will continue to rise, you’ll be willing to pay a higher price now.
• Increased money supply: One of the things governments can do to support the economy in times of crisis is physically give people money to spend. The United States did this most recently in response to the COVID-19 pandemic. More money is more money to spend, which increases demand for goods and services.
• Increased demand: Demand can rise for a particular good or service. For example, say that your favorite rock star announces this is their farewell tour. Demand for tickets goes through the roof because everyone wants to see them one last time. Of course, by the fifth farewell tour, you realize how well artists understand supply and demand.
• Supply chain issues: A really good example of this happened when government shutdowns of many facilities during COVID-19 led to issues getting things restarted. For instance, cars have been harder to come by because semiconductor manufacturers switched to other supply lines when orders for car chips stopped.

The effects of demand-pull inflation are going to be varied. If you have something like the concert tickets, the increased demand is going to mean you’ll just end up paying a higher price because there’s a limited number of seats. If it’s a supply chain issue, eventually production will resume the previous levels and prices should moderate. It just depends.

Built-In Inflation

Built-in inflation occurs when consumers get so used to the current inflationary environment that it leads to more inflation. You can think of this as a continuous upward cycle. Because prices are higher, people demand higher wages. This leads to greater business costs, which in turn leads to more inflation.

This is the most insidious type of inflation because if it takes hold, prices could continue rising indefinitely. And because there’s always a limit to the budget, businesses are unlikely to be able to continue paying employees ever higher incomes. Eventually, you end up with decreased standards of living.

Built-in inflation is probably the biggest thing the Fed is trying to avoid more than anything else. That could create stagflation, characterized by both rising prices and a recession.

If you’re trying to calculate inflation, the way to do it is to take a fixed basket of goods and services and compare the previous year to the current one. Over a longer term, this is how it’s usually done, but you can also use the same procedure to compare one month to the next.

Beyond that, things get a little complicated because the inflation rate depends on who you ask. There are actually three different popular metrics for inflation.

The Consumer Price Index (CPI) looks at how much a consumer pays for goods. On the other hand, the Producer Price Index is about how much it actually costs to bring goods and services to market.

The Fed’s preferred inflation metric is something called Personal Consumption Expenditures (PCE). The same question is asked as CPI, but businesses are asked to provide the info. Beyond the differences in the survey group, the other big difference between CPI and PCE is the way things are weighted.

As an example, one of the biggest differences is how the two indexes treat housing. With CPI, housing costs are assumed to make up around 32% of overall budgets. While there’s not an apples to apples category comparison, for both owners’ equivalent rent and the cost of renting a primary residence, the importance is much lower in the PCE.

On one hand, as we’ll talk about in just a second, housing is a major expense that in some ways is growing. However, it’s also an investment in the same way a stock is. We buy them and one of the goals is to sell for more than what we paid. It’s not something where we use it and have to buy another one in a year.

Like anything else, if home prices go up, it contributes to inflation. While the extent depends on which index you choose to look at, there is no doubt that housing is a significant portion of our budgets and thus a major factor in inflation.

Stipulating that housing has the potential to have a major impact on overall inflation, let’s briefly go over the state of the housing market to quantify just how much.

The latest release from the S&P CoreLogic Case-Shiller 20-city non-seasonally adjusted home price index shows that home prices were up 20.5% as of May compared to the same time a year ago. That’s also a 3-month rolling average to smooth ups and downs. So there’s no dispute that prices are way up.

However, one of the things that has supported ever-increasing home prices is the low mortgage rate environment we’ve had for much of the last decade. Now rates are starting to rise and we’re starting to see the effects of that. Prices for existing homes may still be up 10.8% on the year at a median of $403,800. However, that is down $10,000 from a record high in June.

As rates rise, prices may begin to moderate a bit.

The Federal Reserve is charged with combating inflation. There are a couple of things that it’s doing at the central bank level. But what consumers do is ultimately the decider in how long inflation persists.

The main way the Federal Reserve controls inflation is by trying to influence the level of demand. Fed governors will never tell you to buy or not buy something, but they do control the federal funds rate. This is the rate at which banks borrow money from each other overnight. The important thing to realize here is that this has an effect on every other interest rate lenders set.

As the federal funds rate goes up, so does the cost of borrowing for consumers. This has led directly to rising interest rates for everything from credit cards and personal loans to mortgages. This has an impact on inflation because you’ll spend more if it’s cheap to borrow money and think twice if borrowing becomes more expensive.

The Fed is aware that housing plays a massive role in the economy. Because of this, one of the things they did at the beginning of the pandemic to stimulate the economy is buy a ton of mortgage bonds. This had the effect of keeping mortgage rates low because the rate of return doesn’t have to be as high if you know there’s a willing buyer out there.

This was great for stimulating the economy, but it also likely had the effect of supporting astronomically high prices in the housing sector. The Federal Reserve began selling mortgage bonds back into the market in June and the process accelerates in September. As the Fed does this, traders have accounted for this in mortgage rates. It’s hoped that home prices moderate.

Of course, this whole thing depends on what consumers do. If they continue to pay higher and higher prices, prices will continue to rise. If they choose to keep their money in the bank rather than spending it beyond a certain level, inflation will eventually calm down. Whether that happens remains to be seen.

Inflation is the extent to which prices rise over time. Cost-push inflation occurs when prices rise for reasons not related to demand. Demand-pull inflation is when increased interest in a product or service or a shortage of supply leads to higher prices. Built-in inflation occurs because people expect prices to keep rising, so they’ll pay a higher price now and there’s an upward cycle.

There are a few different ways we measure inflation in the U.S., but any way you look at it, housing has a huge part. For this reason, it’s been one of the Fed’s major focuses along with raising overall interest rates.

If you’re in the market for a house at the moment, you might want to check out how inflation affects mortgage rates. If you’re ready to buy or refinance a home, you can get approved online or give us a call at (833) 326-6018.