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What You Need to Know About Inflation

High inflation and the consequences of attempts to curb it are a top concern for investors nowadays. By hiking rates, policymakers can eventually slow demand to subdue price pressures, even in an environment of constrained supply. However, this process takes time.

Prices reflect the interaction between supply and demand: when demand outstrips supply, prices must rise to re-equilibrate the economy. In fact, supply-side constraints are beyond the purview of monetary policy. In other words, many of the forces pushing prices up are beyond central banks’ control so they cannot solve these issues by changing interest rates. What they do is to slow demand such that even in an environment of constrained supply, price pressures abate, which means tightening monetary policy to slow growth to a rate consistent with the ability of the supply side of the economy to keep pace.

Once rates rise, it takes time for the economy to feel the effect in full. Higher policy rates will not translate immediately into lower demand, slower growth and an easing of inflationary pressures; however, as this year progresses, we can expect growth to slow, bringing inflation gradually lower.

As part of the growth slowdown, consumers will increasingly spend on services rather than goods. Another part of the upcoming rotation is a natural re-equilibration in an environment of higher prices. Since demand for goods has been robust and goods trade has been particularly impacted by supply-chain disruptors, goods price inflation has soared. Food prices, in particular, have risen largely due to high crop prices. 2021 was particularly a bad year for supply, as weather limited planting in many regions and interfered with the growing season. This has made services comparatively affordable and thus more attractive.

However, the shift from goods consumption back to services may take longer than expected. While airlines, hotels and restaurants make headlines, nearly half of the gap in services demand is for medical services. Some of this is likely to be from postponed elective procedures, which could rebound sharply when people feel more comfortable resuming daily life. However, people may take it longer to reach that point.

Prices do not have to fall for inflation to decelerate. Inflation measures the rate of change in prices rather than the price level. Importantly, inflation is not just a one-time change in prices, but a persistent increase. Even if prices simply rise at a slower pace, inflation will turn lower. This means that over time, goods prices and services prices will converge and that inflation will eventually fall below services inflation. Pushing goods prices inflation lower will make a big difference in overall inflation, though it will not solve the problem entirely.

One of the biggest categories of services inflation is how the consumer price index captures the cost of housing. Housing is the part of the economy most sensitive to monetary policy. Mortgage rates in the US have soared and housing prices have risen over the past few years so affordability is extremely low. Subsequently, mortgage applications have fallen sharply and sales of homes, both new and existing homes, have turned down. This suggests that home prices are likely to slow their rate of increase, which should eventually bring services inflation lower too.

To understand ongoing increases, it helps to look at inflation on a month-over-month basis. Doing so eliminates past price rises from the equation, so investors can focus on what is changing now and in the future. The best way to monitor progress toward the outcome is through a broader assessment of financial conditions. Measures and indicators such as lower equity prices, wider credit spreads and higher Treasury yields all work to slow demand by transmitting monetary policy from central banks to the economy. The current financial conditions indicate an economic slowdown is in motion and will in turn bring inflation lower. The key question over the medium term is how aggressively central banks will tighten policy once evidence of slowing growth mounts. Inflation tends to lag the cycle, staying high even after growth slows. If central banks remain aggressive during that interval, the risks of a recession rise sharply.

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