A significant increase in costs, especially as measured by the Producers Purchase Index, has led to a more serious discussion of inflation than we have seen in over a decade. While serious economists aren’t panicking about inflation yet, it’s undeniable that costs are going up, and this could have significant impacts to stocks, bonds, and other assets in the future.
To understand what’s going on, we should first distinguish between two types of inflation. On the one hand there’s cost-push inflation, which is when a decline in the overall supply of goods and services results in higher prices. This happens if demand does not decline at the same rate; there’s a lot of buyers for stuff and less stuff to buy, so prices rise.
On the other hand, there is demand-pull inflation, which is when demand for goods and services rises faster than the supply can increase. When there are more and more buyers but the amount of goods and services doesn’t rise at the same rate, more competition from buyers results in higher prices.
Generally, demand-pull inflation is preferable, because it is the result of an expanding economy. Cost-push inflation is more worrying; it is the result of a lack of supply, a lack of production capacity, or possibly both. Scarcity of goods when demand rises can cause a spiraling effect, whereas a surge in demand will tend to cause production to rise–even if that rise in production comes a bit late.
Herein lies the reason for more intense worry about inflation today than in decades; while rising inflation in the 80s and 90s in the U.S. was demand-pull driven, and inflation in the 00s and 10s in Asia was also demand-pull driven, the scarcity of goods driving prices up phenomenon has not been around since the 1970s–a time of extreme uncertainty and disastrous economic trends.
Ultimately, the market adjusted and a growth in production caused that inflationary trend to subside. Today, because the inflationary trends are cost-push, we need a similar revolution in production. This is troublesome, because the bottlenecks we are currently seeing are hard to overcome. Due to the pandemic, production capacity at factories has fallen significantly (see the computer chip shortage as an example), while the ability to ship goods worldwide has also declined due to the pandemic (less workers in the market, demands for social distancing, quarantine restrictions, export bans, and so on).
Obviously, this pressure on supply will end when vaccinations have gotten humanity to herd immunity. But with the glacial release of vaccines in many parts of the world, that point seems to be far in the future.
As a result, macroeconomic models that inform asset valuations will need to make estimates of when these restrictions to production capacity will end, and a lot of non-financial and non-economic guesswork is involved there. For this reason, all asset prices on the whole may be significantly mispriced (either to the upside or downside) because of just how hard it is to estimate how much the pandemic’s after effects will hit production.