Cost-Push Inflation

Cost Push Inflation
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The interaction between supply and demand is how prices are set in the economy. Too much demand or too little supply can mean higher prices and inflation for everybody.

Cost-push inflation happens when there is a decline in the supply of goods and services and demand remains unchanged or even grows, driving prices and inflation higher.

What Is Cost-Push Inflation?

When there is a disruption in the supply of goods and services, prices are pushed higher by cost-push inflation. With less supply but unchanged or higher demand, companies raise their prices, pushing up inflation.

Cost-push inflation occurs when demand remains static or grows even when prices climb higher. If demand for goods or services falls when the prices rise, then inflation remains subdued.

Except for essential goods and services, demand usually declines before cost-push inflation sets in, which makes this particular type of inflation relatively rare.

Cost-Push Inflation vs. Demand-Pull Inflation

Cost-push and demand-pull inflation are the flip sides of the supply-and-demand coin. When a supply shortage happens—due to a natural disaster, an increase in labor prices or supply chain problems—companies typically respond by increasing their prices to cover higher production costs. This is referred to as cost-push inflation.

Demand-pull inflation is when growing demand for goods or services meets insufficient supply, which drives prices higher.

What Causes Cost-Push Inflation?

There are a few ways that cost-push inflation gets started.

  • Shortages or cost increases in labor, raw materials or capital goods may cause companies to cut back on production to cut costs. These phenomena can also increase overall supply costs, which companies decide to pass on to consumers.
  • Supply chain problems may also occur for other reasons, like monopolies that drive up prices, natural disasters, new regulations or changes in exchange rates for goods shipped from overseas.
  • In a cost-pull inflation scenario, demand for a product or service remains the same, even as the price to keep up supply for those products or services increases, or supply simply falls short. If the demand for a product decreases as the price increases, then prices tend to stabilize and cost-push inflation is avoided.

Example of Cost-Push Inflation

Although cost-push inflation isn’t as common as other forms, there are still some prominent real-world examples.

The most common example of cost-pull inflation is with fossil fuels made from crude oil since it’s difficult for consumers to cut back on these products even when prices increase.

OPEC and the Oil Crises of the 1970s

The Organization of Petroleum Exporting Countries (OPEC) controls most of the world’s oil reserves. In 1973 it decided to restrict production, which caused prices to increase by 400%. Companies that relied on oil and gas were impacted as their production costs rose, leading them to pass those price increases to the consumer to keep up.

How Is Inflation Measured?

Several factors need to be taken into account to determine inflation. For this reason, economists use three price indexes to measure inflation in the U.S.

  • The Consumer Price Index (CPI) measures what consumers pay for goods and services in eight categories. These include food and beverage, apparel, transportation, education and communication, recreation, medical care, and other goods and services.
  • The Personal Consumption Expenditures Price Index (PCE) tracks the prices that businesses receive for goods and services and follows a broader range of purchases. Core PCE is the Federal Reserve’s preferred rule for measuring inflation.
  • The Producer Price Index (PPI) measures prices received by domestic producers for output. Producers who face problems like an increase in labor prices or an issue at a factory may then run into problems with supply. If demand remains the same when supply falls, cost-push inflation may occur.

Cost-Push Inflation and the Fed

The Fed is tasked with helping to monitor the U.S. economy and keep it stable. Using 2% as a measure for a stable rate of inflation, the Fed then makes monetary policy decisions intending to move the economy in the right fiscal direction.

Occasionally these measures may end up driving up cost-push inflation. For example, increasing the federal funds rate to curb overall consumer spending may hurt business spending and supply.

If this happens, but demand for those products remains the same, then cost-push inflation can occur.

What Investments Beat Inflation?

During periods of high inflation, saving money in the bank or in cash means your purchasing power will decrease over time. Instead, consider the following investments:

  • Stocks. Although individual stocks may decrease in value, investing in a diversified broad market index fund tends to beat inflation and can grow your money over the long run.
  • Bonds. Bonds offer lower returns than stocks, but if you’re a risk-averse investor or are approaching or are already in retirement, you may want the more consistent returns of investments in bonds and bond funds to help beat inflation.
  • Treasury Inflation-Protected Security (TIPS). These U.S. Treasury bonds are designed to protect investors from inflation by using changes to the CPI to adjust investment value.

Can You Beat Inflation with Gold?

Some investors think investing in gold is a great way to avoid inflation, but gold can be tricky. Gold’s value wildly fluctuates over time, but it’s also impacted by outside factors like supply and demand, global currencies, and central bank policy.

It can also be pricey to find a safe place to store your gold, and if you’ve owned it for more than a year, it will probably incur a higher long-term capital gains tax rate than stocks and bonds when you try to sell it.

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