Hermione TaylorAs the global economies emerge from the pandemic, the inflationary pressure couldn’t be more relevant. While the Consumer Price Index (CPI), the most common inflation indicator, is surging around the globe, does it tell us the full story – and are there alternative measures of inflation that investors should be looking out for?
How inflation is measured: the role of CPI
CPI is the most commonly quoted measure of inflation and is often used in international comparisons and to evaluate the impact of policies such as interest rate cuts. Calculating inflation using this indicator involves constructing a so-called ‘basket’ of goods and services, which is designed to provide a broad reflection of the prices experienced by consumers in a country.
In the US, the world’s biggest economy, the CPI figure spiked to 5.4% in June and July, the highest level in 13 years and well above the Federal Reserve’s target of 2%, raising troubling questions among the investor community.
US CPI Inflation rate, Source: TradingEconomicsYet the CPI indicator has its limitations, which has only been heightened by the pandemic. Oil prices, for example, were so artificially low on the back of the 2020 oil crash that the base year used to calculate changes in anything energy-related has been distorted.
Plus, prices for some basket components had to be estimated as COVID-19 forced entire industries to close. There is therefore a lot of ‘noise’ in CPI measures, which can make it very hard to tell if inflation is going to be sustained or transitory.
Alternative measures of inflation: Core CPI, PPI, wage growth
Other inflation indicators can provide a broader perspective. ‘Core CPI’, for example, strips out more volatile food and energy prices and suggests lower levels of underlying inflation for the US.
US Core inflation rate VS CPI Inlfation rate; Source: TradingEconomicsThe Producer Price Index (PPI) is also a useful indicator and can highlight the danger of focusing exclusively on CPI inflation as experienced by the consumer. The latest figures suggest that prices facing manufacturers in China are up 9%, even though CPI sits much lower.
China CPI Inflation rate VS PPI Change; Source: TradingEconomicsLooking at the actual and expected wage levels can provide insight into whether higher inflation is likely to be transitory or longer term. Although wages are growing in the US, figures suggest this may be due to the short-term readjustment of re-opening. US Labour surveys, for example, suggest that US workers are anticipating low inflation in the coming months, meaning they are less likely to demand wage increases.
What causes inflation, and what is driving it now?
While every indicator may tell a different story, it’s important to understand the factors that drive inflation, which tend to be either surging demand or a frustrated supply – and often a combination of both.
First, the demand side: over the course of the pandemic, many consumers in developed economies built up ‘excess savings’, which have the potential to fuel consumption as the economy re-opens.
In the US, for example, the proportion of savings as a percentage of disposable income reached a record level of 33.8% in April, a sharp increase from the pre-pandemic level of around 8%. Plus, many economies are still affected by COVID-related government support, and post-pandemic reopening has certainly led to unusual patterns of spending.
There are also real pressures on the supply side, with environmental issues contributing to high commodity prices, reflected in surging prices for oil, metals, and some agricultural products.
July 2021 was the hottest month on record, contributing to wildfires in the Mediterranean, Turkey, and Russia, which scorched fields and pushed up crop prices. Drought in Brazil also led to record energy prices as hydroelectric power faltered.
Suppliers are also having difficulties as they try to adjust stock levels to keep up with demand as economies re-open. Many smaller firms kept low levels of stock during the pandemic and are now struggling to catch up, with imported orders taking weeks to arrive. The US retailer sales-to-inventories ratio plunged to all-time lows at the start of the year, with reports suggesting that shops were running out of products to sell.
While it is likely these will prove to be short-term issues, there are also concerns that some longer-term supply-side pressures could persist. ‘Greenflation’, which means higher costs incurred from regulations and environmental taxes, is a good example of that. Plus, pressure on wages from a decline in the working population could also lead to sustained higher prices.
Should we worry if inflation is above target?
CPI targets seem to imply that there is an ‘ideal’ rate of inflation. Yet the US economy, among many others, is currently seeing inflation overshooting the 2% benchmark. Is this necessarily a concern?
Even in the short term, high inflation carries risks. If consumers anticipate speedy price growth, they are likely to demand higher wages, leading to further surges in inflation which can trigger dangerous wage-price spirals. These are a significant concern for governments and highlight the value of looking at wage growth and inflation expectations metrics as supplementary indicators.
When central banks consider runaway inflation risk, they tighten monetary policy by hiking interest rates, as currently seen in Brazil, Russia, and Mexico. Higher rates have an impact far beyond the country’s own borders.
When major markets increase interest rates, they become more attractive to investors, prompting a rush of capital from developing countries where rates are lower. These so-called currency wars can lead to rapid depreciation and significant volatility in FX rates.
Sustained inflation can also impact longer-term investments. When producer prices increase, it is hard to predict how companies will respond. Will they pass on these higher prices to consumers or try to absorb them by lowering costs? Luckily, there are strategies investors can use to hedge against inflation.
Inflation indicators: the bottom line
Though CPI remains the most commonly cited measure of inflation, it often belies a more complex reality. Just as forecasters use a basket of goods to calculate a broad measure of consumer inflation; we may need to use a basket of inflation indicators to gain a clearer picture of what is driving increased prices and how likely they are to endure.
Edited by Jekaterina Drozdovica
